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What Do HFTs Really Do? Competition, Volatility, and Market Structure

This paper reveals that high-frequency trading (HFT) is not one big strategy—but three distinct types. It shows that when HFTs compete in market-making, volatility actually goes down, and smaller exchanges become more viable.

💡 Takeaway:
HFT firms fall into three strategy types: market making, cross-venue arbitrage, and short-term directional trades. Competition among them improves price discovery and liquidity—especially on smaller exchanges:

  • Market Making: These traders help keep markets running smoothly by constantly offering to buy and sell. They earn small profits from the price difference between buying and selling. More competition here means better prices and less market noise.

  • Cross-Venue Arbitrage: These traders spot price differences for the same stock on different exchanges and quickly trade to profit from them. Their actions help keep prices consistent across markets.

  • Short-Term Directional Trading: These traders try to guess which way prices will move in the next few seconds or minutes. They trade fast and often during volatile times, trying to ride short bursts of momentum.

Key Idea: What Is This Paper About?

The paper analyzes 31 HFT firms using Canadian regulatory data. By decomposing activity patterns with PCA, it identifies three distinct HFT strategy categories. It then shows that when multiple HFTs compete using similar strategies (especially market making), it lowers short-term volatility and boosts smaller trading venues’ competitiveness.

Economic Rationale: Why Should This Work?

📌 Relevant Economic Theories and Justifications:

  • Product Differentiation (Tirole, Hotelling): Differentiated strategies reduce direct competition; similar strategies mean intense rivalry.
  • Inventory Models (Ho & Stoll): Market makers adjust quotes to manage inventory and risk; competition tightens spreads.
  • Price Impact Decomposition: More competition → lower permanent and temporary price impact → less volatility.
  • Cross-Venue Arbitrage: HFTs enforce price consistency across fragmented markets, improving efficiency.

📌 Why It Matters:
HFT isn’t monolithic. Some strategies benefit markets more than others. Market-making HFTs, when competing, reduce rents and volatility, contradicting the fear that HFTs always add instability.

Data, Model, and Strategy Implementation

Data Used

  • Source: IIROC order-level data (Canada)
  • Period: June 2010 – March 2011
  • Assets: 52 stocks from the S&P/TSX 60
  • Granularity: Full limit order book data with user/trader IDs across 5 exchanges

Model / Methodology

  • PCA Decomposition: Extract 3 strategy components from HFT firm activity (messages, trades, cancels)
  • Strategy Classification:
    1. PC1: Cross-venue arbitrage
    2. PC2: Market making
    3. PC3: Directional speculative trading
  • Competition Measure: Correlation of strategies across firms = similarity = competition
  • Regression Framework:
    • Volatility explained by strategy similarity
    • Venue competitiveness regressed on HFT similarity
    • Price impact channels analyzed (permanent vs. temporary)

Final Thought

💡 Not all HFT is created equal. Competitive market makers can lower volatility and make markets better. 🚀

Paper Details (For Further Reading)

  • Title: The Competitive Landscape of High-Frequency Trading Firms
  • Authors: Ekkehart Boehmer, Dan Li, Gideon Saar
  • Publication Year: 2018
  • Journal/Source: The Review of Financial Studies
  • Link: https://www.jstor.org/stable/10.2307/48615702
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