High‐Frequency Trading and the Execution Costs of Institutional Investors

Published date01 May 2014
Date01 May 2014
The Financial Review 49 (2014) 345–369
High-Frequency Trading and the Execution
Costs of Institutional Investors
Jonathan Brogaard
FosterSchool of Business, University of Washington
Terrence Hendershott
Haas School of Business, University of California Berkeley
Stefan Hunt
Financial Conduct Authority
Carla Ysusi
Financial Conduct Authority
This paper studies whether high-frequency trading (HFT) increases the execution costs of
institutional investors. Weuse technology upgrades that lower the latency of the London Stock
Exchange to obtain variation in the level of HFT over time. Following upgrades, the level of
HFT increases. Around these shocks to HFT institutional traders’ costs remain unchanged. We
find no clear evidence that HFT impacts institutional execution costs.
Corresponding author: Foster School of Business, University of Washington, 434 Paccar Hall, Box
353226, Seattle, WA98195; Phone: (206) 685-7822; Fax: (206) 513-7472; E-mail: brogaard@uw.edu.
The views in this paper are solely those of the authors and do not reflect the views of the Financial Conduct
Authority (FCA) or any of the trading venues or market participants mentioned in the paper.All errors or
omissions are the authors’ sole responsibility. No stock exchange is party to this research or responsible
for the views expressed in it. References in this report to data from the exchanges refer to information
provided by the exchange to the FCA at the FCA’s request. The data provided by the exchange to the
FCA are anonymous. All data are aggregated and specific member firms and their activities cannot be
identified. Wethank the anonymous referees and the editor for helpful comments.
C2014 The Eastern Finance Association 345
346 J. Brogaardet al./ The Financial Review49 (2014) 345–369
Keywords: high frequency trading, execution costs, institutional investors
JEL Classifications: G10, G23, O16
Institutional investors also have expressedserious reservations about the current equity
market structure. . . . [I]nstitutional investors questioned whether our market structure
meets their need to trade efficiently and fairly, inl arge size.
Mary Schapiro, SEC Chairman, September 7, 2010 speech.
1. Introduction
Transaction costs matter.1Financial markets exist so investors can efficiently
transfer assets and their associated payoffs and risks; the cheaper it is to transfer
an asset, the more likely the most-suited investor will end up holding the asset. In
addition, with lower transaction costs, investors with private information can more
readily buy and sell, aiding price discovery.
High-frequency trading (HFT) accounts for an increasingly large fraction of
financial market trading, potentially affecting transaction costs. HFT is a subset of
computer-based trading, defined by the use of sophisticated trading algorithms and the
ability to trade rapidly to generate returns. Until recently, human intermediaries, such
as NYSE Specialists and registered market makers, facilitated the smooth transfer of
assets. Now, many human market makers have been substituted by computers.
While the rise of machines has raised concern, most academic evidence suggests
it has improved measures of market quality such as volatility, price discovery, and
liquidity. For example, Menkveld (2013) studies the entrant of a new HFT firm,
and finds that after the HFT firm enters, spreads decrease by 50%. Malinova, Park
and Riordan (2013) show that an increase in order submission fees results in a
decrease in order submissions, and therefore the cost of trading for retail investors
increases. Carrion (2013) shows that HFT firms provide more liquidity when spreads
are wide. Brogaard, Hendershott and Riordan (2013) find that HFT contributes to
price discovery. We contribute to the literature by examining the link between HFT
activity and institutional trading costs.
Even though market-wide measures of market liquidity may improve, including
the spread, this does not necessitate that institutional investors are better off.2The
improvement in market quality may be only for a select group of market participants.
1We use the term “transaction costs” to mean all costs incurred in financial trading, including execution
cost, commissions and rebates, information technology costs and other costs. We use the term “execution
costs”—synonymously,trading costs—to mean market-adjusted execution shortfall, the volume-weighted
percentage difference between the price available in the market when brokers receiveinstitutional orders
and the price at which the order is executed.
2Institutional investors refer to buy–sideinstitutions such as pension plans and money managers. Our data
come from Abel Noser, a well-known consulting firm that works with pension plan sponsors and money
managers to monitor their equity trading costs.

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