Toxic Arbitrage

01 September 2017

High-frequency trading does cause damage to market liquidity, new study finds

In response to the hot debate between academics and professional groups (regulators, traders and so forth) on the role of High Frequency Trading (HFT) in stock markets, Dr Roman Kozhan, and colleagues, carried out an empirical study to explore this topic further.

Arbitrage refers to the practice of taking advantage of a price difference between two or more markets. Arbitrageurs, people who engage in arbitrage, would perform a combination of matching deals to capitalize on the price discrepancy, with the aim of making a profit from the difference in market prices. There has been growing literature documenting the positive effect of high-frequency arbitragers on market efficiency and liquidity.

This study found that high-frequency arbitrages do in fact cause some damage to markets in specific situations, termed here as ‘toxic’ opportunities. For example, toxic arbitrage might include a scenario whereby price discrepancy appear due to arrival of new fundamental information and this has the knock-on effect of triggering suppliers to charge large bid-ask spreads to cover the risk of trading at stale prices i.e. prices that do not reflect the newly arrived market information.

Under toxic situations, high-frequency arbitrageurs are in fact damaging the market liquidity, concludes Associate Professor, Roman Kozhan, Warwick Business School. These findings contribute to the debate on this topic and provides insights to financial regulators on how best to police high-frequency trading, using mechanisms that might reduce their current speed advantage.

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