Working Paper: NBER ID: w25972
Authors: Sida Li; Xin Wang; Mao Ye
Abstract: We model competition for liquidity provision between high-frequency traders (HFTs) and slower execution algorithms designed to minimize transaction costs for buy-side institutions (B-Algos). Under continuous pricing, B-Algos dominate liquidity provision by using aggressive limit orders to stimulate HFTs’ market orders. Under discrete pricing, HFTs dominate liquidity provision if the bid–ask spread is binding at one tick. If the tick size is not binding, B-Algos choose between stimulating HFTs and providing liquidity to other non-HFTs. Flash crashes arise under certain parameter values. Transaction costs can be negatively correlated with the bid–ask spread when all traders can provide liquidity.
Keywords: liquidity provision; high-frequency trading; algorithmic trading; market microstructure
JEL Codes: G1; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| balgos' aggressive limit orders (C69) | stimulation of HFT market orders (C69) |
| pricing structure (D49) | liquidity dynamics (E41) |
| market conditions and trader behaviors (G41) | flash crashes (Y10) |
| transaction costs (D23) | bid-ask spread (D44) |