Jour Fixe - Frequent Batch Auctions and Informed Trading
Steffen Eibelshäuser and Fabian Smetak
This paper studies liquidity provision by competitive high-frequency trading firms in a dynamic trading model with private information. Liquidity providers face two sources of adverse selection risk: firstly, risk from trading with investors with superior information and, secondly, risk from trading with other high-frequency trading firms that respond to new public information more quickly and engage in latency arbitrage. In equilibrium, expected losses from liquidity provision are reflected in bid-ask spreads which determine transaction costs for investors. The impact of the two different sources of risk depends on the details of the market design. We determine closed-form representations of equilibrium transaction costs in continuous limit order book (CLOB) markets and under frequent batch auctions (FBA). In the absence of informed trading, FBA dominates CLOB in terms of transactions costs, as in the original paper by Budish et al. (2015). This does no longer hold true with privately informed investors. We show that equilibrium prices in the FBA design allow liquidity providers to charge strictly positive markups and earn profits – even in case of risk neutrality and perfect competition. The underlying mechanism is closely related to bid shading in multi-unit uniform price double auctions. When privately informed trading is sufficiently frequent, the CLOB design leads to lower transaction costs for investors than the FBA design. In any case, both CLOB and FBA are dominated by another market design: liquidity taking access delay (LTAD). LTAD augments the CLOB design with a small asymmetric speed bump for aggressive orders, leading to efficient transaction costs in our model.