The microstructure of high frequency markets

TL;DR

This paper introduces a new framework for understanding high frequency market microstructure, emphasizing a novel notion of informed traders and market frictions, supported by empirical data and applications to profit measurement and option hedging.

Contribution

It presents a new model of informed traders with superior information and a rigorous description of market clearing conditions, revealing significant impacts of frictions on market dynamics.

Findings

High frequency traders possess a form of superior information distinct from insider trading.

Ignoring market frictions can lead to a 50% misestimation of wealth exchanged.

Market frictions significantly influence delta-hedging strategies in options pricing.

Abstract

We present a novel approach to describing the microstructure of high frequency trading using two key elements. First we introduce a new notion of informed trader which we starkly contrast to current informed trader models. We describe the exact nature of the `superior information' high frequency traders have access to, and how these agents differ from the more standard `insider traders' described in past papers. This then leads to a model and an empirical analysis of the data which strongly supports our claims. The second key element is a rigorous description of clearing conditions on a limit order book and how to derive correct formulas for such a market. From a theoretical point of view, this allows the exact identification of two frictions in the market, one of which is intimately linked to our notion of `superior information'. Empirically, we show that ignoring these frictions can misrepresent the wealth exchanged on the market by 50%. Finally, we showcase two applications of our approach: we measure the profits made by high frequency traders on NASDAQ and re-visit the standard Black - Scholes model to determine how trading frictions alter the delta-hedging strategy.