Working Paper: NBER ID: w23457
Authors: Maryam Farboodi; Laura Veldkamp
Abstract: In most sectors, technological progress boosts efficiency. But financial technology and the associated data-intensive trading strategies have been blamed for market inefficiency. A key cause for concern is that better technology might induce traders to extract other's information from order flow data mining, rather than produce information themselves. Defenders of these new trading strategies argue that they provide liquidity by identifying uninformed orders and taking the other side of their trades. We adopt the lens of long-run growth to understand how improvements in financial technology shape information choices, trading strategies and market efficiency, as measured by price informativeness and market liquidity. We find that unbiased technological change can explain a market-wide shift in data collection and trading strategies. But our findings also cast doubt on common wisdom. First, although extracting information from order flow does crowd out production of fundamental information, this does not compromise price informativeness. Second, although taking the opposite side of uninformed trades is typically called "providing liquidity," the rise of such trading strategies does not necessarily improve liquidity in the market as a whole.
Keywords: financial technology; market efficiency; price informativeness; market liquidity
JEL Codes: E20; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Unbiased technological change (O33) | Market-wide shift in data collection and trading strategies (G14) |
| Extracting information from order flow (C69) | Reduces production of fundamental information (D89) |
| Extracting information from order flow (C69) | Price informativeness (G14) |
| Rise of order flow trading (C69) | Market liquidity (G19) |
| Expectation of informed trading (D84) | Future information risk (D80) |
| Future information risk (D80) | Price impacts (F69) |
| Future information risk (D80) | Liquidity stagnation (E41) |
| Technological progress in information processing (O33) | Trading strategies (G13) |
| Technological progress in information processing (O33) | Market efficiency (G14) |