Working Paper: CEPR ID: DP9925
Authors: Thierry Foucault; Roman Kozhan; Wing Wah Tham
Abstract: High frequency arbitrage opportunities sometimes arise when the price of one asset follows, with a lag, changes in the value of another related asset due to information arrival. These opportunities are toxic because they expose liquidity suppliers to the risk of being picked off by arbitrageurs. Hence, more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these opportunities impair liquidity. We find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In our sample, a 1% increase in the likelihood that a toxic arbitrage terminates with an arbitrageur's trade (rather than a quote update) raises bid-ask spreads by about 4%.
Keywords: Adverse Selection; Arbitrage; High Frequency Trading; Liquidity
JEL Codes: D50; F31; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| likelihood that a toxic arbitrage opportunity terminates with an arbitrageur's trade (p_t(c)) (G13) | bid-ask spreads (G19) |
| speed of arbitrageurs (G19) | market illiquidity (G10) |
| fraction of toxic arbitrage opportunities (G19) | market illiquidity (G10) |
| speed of arbitrageurs (G19) | market liquidity (G10) |