Middlemen in Limit - Order Markets 1 Boyan Jovanovic and

Middlemen in Limit-Order Markets A limit-order market enables an early seller to trade with a late buyer by leaving a price quote. But, public news in the interarrival period creates adverse selection for the seller and therefore hampers trade. High-frequency traders/machines (HFT) might restore trade by bringing the capacity to quickly update quotes on news. A theoretical model shows that HFT entry can indeed increase welfare, but it might just as well destroy it. Empirically HFT entry coincided with a 13% reduction in the effective bid-ask spread and an unchanged trade frequency. [insert Figure 1 here] Successful entry of new limit-order markets has changed the industry of securities trading. Figure 1 illustrates how the NYSE had an 80% market share in its listed stocks in 2003, yet only 25% in 2011. Technology facilitated the entry of cheap and fast electronic limit-order markets. BATS is an example of a successful entrant market. It started in June 2005, picked up significant market share in 2007, and gradually grew to a 10% share in 2011. Europe showed a parallel trend. Chi-X started in April 2007 and captured a 15% market share in European equity trading. The London Stock Exchange, an incumbent, saw its market share plummet from 30% in 2008 to 20% in 2011. Coincidentally, high-frequency traders (HFTs) have become the most active participants in equity markets. The Securities and Exchange Commission (SEC) published a policy document that refers to HFT as " one of the most significant market structure developments in recent years.. . it typically is used to refer to professional traders acting in a proprietary capacity.. . characteristics often attributed to proprietary firms engaged in HFT are.. . the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders.. . very short time-frames for establishing and liquidating positions.. . ending the trading day in as close to a flat position as possible.. . estimates of HFT volume in the equity markets vary widely, though they typically are 50% of total volume or higher (SEC (2010, p.45)). " 1 High-frequency traders are therefore naturally thought of as middlemen in particular due to the proprietary nature of their trading and the short holding period (milliseconds, seconds, minutes, or at most hours). This paper studies how high-frequency trading might affect investor welfare in limit-order markets both theoretically and empirically. A limit order is a pre-commitment to buy or sell …