The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response

Peter Cramton, Eric Budish and John Shim , Quarterly Journal of Economics 130(4) , 1547-1621 , November 2015.

The high-frequency trading arms race is a symptom of flawed market design. Instead of the continuous limit order book market design that is currently predominant, we argue that financial exchanges should use frequent batch auctions: uniform price double auctions conducted, e.g., every tenth of a second. That is, time should be treated as discrete instead of continuous, and orders should be processed in a batch auction instead of serially. Our argument has three parts. First, we use millisecond-level direct-feed data from exchanges to document a series of stylized facts about how the continuous market works at high-frequency time horizons: (i) correlations completely break down; which (ii) leads to obvious mechanical arbitrage opportunities; and (iii) competition has not affected the size or frequency of the arbitrage opportunities, it has only raised the bar for how fast one has to be to capture them. Second, we introduce a simple theory model which is motivated by, and helps explain, the empirical facts. The key insight is that obvious mechanical arbitrage opportunities, like those observed in the data, are built into the market design – continuous-time serial processing implies that even symmetrically observed public information creates arbitrage rents. These rents harm liquidity provision and induce a never-ending socially-wasteful arms race for speed. Last, we show that frequent batch auctions directly address the flaws of the continuous limit order book. Discrete time reduces the value of tiny speed advantages, and the auction transforms competition on speed into competition on price. Consequently, frequent batch auctions eliminate the mechanical arbitrage rents, enhance liquidity for investors, and stop the high-frequency trading arms race.

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