Securities Regulation.

• Author: Van Doren, Peter

* "Quantifying the High-Frequency Trading 'Arms Race': A Simple New Methodology and Estimates," by Matteo Aquilina, Eric Budish, and Peter O'Neill. SSRN Working Paper no. 3636323, June 2020.

* "Innovation in the Stock Market and Alternative Trading Systems," by Gabriel Rauterberg. SSRN Working Paper no. 3728768, December 2020.

No development in financial markets currently causes more discussion and disagreement than high-frequency trading (HFT). Forty years ago, the "making" of a market in equities was done by "specialists" who owned seats on exchanges. They were compensated by the "spread"--the difference between the price they offered sellers and charged buyers. Those differences were large enough to more than cover costs. The excess profits were capitalized in the prices that specialists paid for the right to trade on an exchange.

Now liquidity is provided by traders using computers. In a previous Working Papers column (Winter 2013-2014) I reported that many commentators view this change positively because the costs of trading have been dramatically reduced along with the rents to specialists. Bid-ask spreads have decreased over time and revenues to market-makers have decreased from 1.46% of traded face value in 1980 to just 0.11% in 2006 and 0.03% in 2015. And HFT reduces stock price volatility. When the temporary ban on short sales of financial stocks existed in 2008, the financial stocks with the biggest decline in HFT had the biggest increase in volatility.

Those who emphasize the costs of HFT focus on an "arms race" among HFT participants to locate their servers closer and closer to the servers of electronic exchanges. This arms race exists because the transfer of buy and sell offers from any of the actual computerized exchanges to the National Market System (NMS) takes real time. This creates the possibility of learning about prices at a computerized exchange and trading on that information through the NMS before the NMS posts the information. Traders have responded to these facts by paying to locate their servers in the same location as exchange servers, utilizing the speed of light to arbitrage price differences at the level of thousandths of a second (latency arbitrage).

In a previous Working Papers column (Fall 2015) I described research that demonstrated that the arms race is the result of exchanges' use of a "continuous-limit-order-book" design (that is, orders are taken continuously and executed in the order of arrival). In...