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High-frequency trading synchronizes prices in financial markets

High-speed computerized trading, often called high-frequency trading, has increased dramatically in financial markets over the last decade.  It currently accounts for half of all trading in US and European equity markets, and it is quickly growing in Asian, fixed income, commodity, foreign exchange, and nearly every other market.

Why is high-frequency trading so prevalent?  What purpose does it serve and should it be regulated? This research attempts to answer these questions.

Using a special dataset provided by the NASDAQ stock exchange, I’ve found that high-frequency trading largely focuses on price synchronization, i.e., on keeping the prices of related securities aligned with one another.

Price synchronization is important in markets.  To understand why, it is perhaps useful to draw an analogy to animal groups.  Animals that synchronize their movements can scan their environment with “many eyes”, which allows them to quickly and collectively evade threats or find potential food sources (think of schooling fish). 

Financial markets are similar.  In markets, the state of the economy is monitored by a large number of investors who quickly broadcast any changes to each other and the rest of society via price movements.  If prices aren’t synchronized, the “many eyes” of different investors do not operate efficiently.

Using standard economic models (and analogous to what is observed in animal groups), I’ve shown how price synchronization facilitates information transfer in markets.  When information quickly flows between securities, prices are more accurate and transaction costs are reduced.  Both effects have been observed in markets over the last decade as high-frequency trading has increased.

Although price synchronization has several beneficial effects, it also introduces novel risks that require monitoring by regulators. When prices are tightly connected to each other, errors will quickly propagate through the financial system if safeguards are not in place.  The rapid fall and subsequent rise in prices that occurred in US markets on May 6, 2010 (known as the “Flash Crash”) was an example of just such error propagation.

Media mentions

"High-Speed Traders Are Like Fish" BloombergView
"Bio-finance? Why high-frequency traders makes stocks flock like birds" Medium
"The beauty of high-speed trading" Time
"In defense of high frequency trading" Pandodaily

 

What's the Big Idea?

High-speed computerized trading, often called high-frequency trading, has increased dramatically in financial markets over the last decade. 

- Austin Gerig