The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response

By Eric Budish, Peter Cramton, John J. Shim. 2015

771 citations recorded by the source corpus.

We argue that the continuous limit order book is a flawed market design and propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple new theory model motivated by these empirical facts. The model shows that the arms race is not only socially wasteful ‐ a prisoner’s dilemma built directly into the market design ‐ but moreover that its cost is ultimately borne by investors via wider spreads and thinner markets. Last, we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.

Subfields: Economics and Econometrics, Finance, Management Science and Operations Research

View Paper: https://www.semanticscholar.org/paper/ab490960df8dc315cc5b4a089c7ce206ea5f7746

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Citations in the corpus

Need for Speed? Exchange Latency and Liquidity (2016, background): “This assumption is standard in classic microstructure theory (e.g., Kyle, 1985) and in more recent HFT theory (e.g., Budish, Cramton, and Shim, 2015; Foucault, Hombert, and Roşu, 2016).”
High frequency market microstructure. (2015, background): “There is general, but not universal, agreement that HFT market making enhances market quality by reducing spreads and enhancing informational efficiency (see Jones, 2012; Brogaard, Hendershott, and Riordan, 2013; Carrion, 2013). Menkveld (2013) provides direct evidence of how the entrance of HFTs re”
The Empirical Analysis of Liquidity (2014, background): “Budish et al. [2014] analyze the implementation details for frequent batch auctions.”
High‐Frequency Trading and Market Performance (2020, neutral): “In Budish, Cramton, and Shim (2015), these signals are exogenous.”
Electricity market design (2017, background): “The model, however, is problematic as it encourages an arms race for speed (Budish et al., 2015).”
What Is the Optimal Trading Frequency in Financial Markets (2017, background): “Budish, Cramton, and Shim (2015) argue that continuous limit order books should be replaced by frequent double auctions.”
Risk and Return in High-Frequency Trading (2018, background): “Budish et al. (2015) show that profits are not competed away under relative latency”
Flash Boys 2.0: Frontrunning in Decentralized Exchanges, Miner Extractable Value, and Consensus Instability (2020, background): “Many economists view this behavior as a zerosum game that profits exchanges in the long term, and argue formally that the existence of such rents is a fundamental limitation of market design that is a natural consequence of arbitrage opportunities across exchanges [7].”
Price Discovery without Trading: Evidence from Limit Orders (2019, background): “…is widely debated by academics, regulators, and investors with concerns often focusing on HFTs using market orders to “pick off” stale limit orders (Foucault, Hombert, and Rosu (2015), Biais, Foucault, and Moinas (2015), Budish, Cramton, and Shim (2015), and Foucault, Kozhan, and Tham (2017)).”
A High Frequency Trade Execution Model for Supervised Learning (2017, neutral): “This perpetual state of needing to invest in infrastructure just to maintain a competitive advantage is an artifact of a ’ﬂawed’ continuous limit order book market design currently predominately deployed by ﬁnancial exchanges (Budish et al., 2015).”
Sparse Signals in the Cross‐Section of Returns (2018, neutral): “Budish et al. (2015) show that the correlation structure of stock returns is different at different horizons.”