Collaborative Research: The Negative Effects of High Frequency Trading and Transparency in Dynamic Markets

Stanford University, Stanford CA

Investigators

Abstract

This award funds research on the design of dynamic markets under conditions of asymmetric information. The designer has a limited set of instruments, and once the design is established the market operates as a competitive market. The goal of the project is to determine how restrictions on the timing of market transactions or mandating transparency about market buy and sell offers affect market outcomes and the overall efficiency of trade in the market. The project has four distinct components. The first compares efficiency of market outcomes for different designs that differ in terms of how frequently the market is open for trades. For example, the team compares outcomes in markets in which buyers make continuous offers to outcomes in markets where after the first offer there is a lock-up period during which no trades can be made. The research establishes conditions under which this kind of trade restriction improves the overall functioning of the market. The second component considers the pros and cons of transparency of past offers in dynamic markets. The research demonstrates that market equilibria are very different when past rejected offers are public information. Less transparency results in more efficient trade. The third component considers possible government interventions in markets with dynamic adverse selection. The results suggest that a policy of holding periodic auctions and subsidizing some initial trades can improve market efficiency. The final component considers competition between marketplaces. The research provides broader impact by shedding new light on the consequences of high-frequency trading, transparency of order flows and certain market institutions found in financial markets. The results will be useful for evaluation of government policy, from regulation of financial markets and competition between marketplaces to a direct intervention by purchases of assets in so called 'frozen' markets to re-establish liquidity.