Electronic copy available at: http://ssrn.com/abstract=1641387
On May 6, 2010 the Dow Jones Industrial Average dropped over 1,000 points inintraday trading in what has come to be known as the “ﬂash crash”. The nextday, some media blamed high frequency traders (HFTs; HFT is also used to referto high frequency trading) for driving the market down (Krudy, June 10, 2010).Others in the media blamed the temporary withdrawal of HFTs from the market ascausing the precipitous fall (Creswell, May 16, 2010).
HFTs have come to makeup a large portion of the U.S. equity markets, yet the evidence of their role in theﬁnancial markets has come from news articles and anecdotal stories. The SEC hasalso been interested in the issue. It issued a Concept Release regarding the topicon January 14, 2010 requesting feedback on how HFTs operate and what beneﬁtsand costs they bring with them (Securities and Commission, January 14, 2010).In addition, the Dodd Frank Wall Street Reform and Consumer Protection Actcalls for an in depth study on HFT (Section 967(2)(D)). In this paper I examine theempirical consequences of HFT on market functionality. I utilize a unique datasetfrom Nasdaq OMX that distinguishes HFT from non-HFT quotes and trades. Thispaper provides an analysis of HFT behavior and its impact on ﬁnancial markets.Such an analysis is necessary since to ensure properly functioning ﬁnancial mar-kets the SEC and exchanges must set appropriate rules for traders. These rulesshould be based on the actual behavior of actors and not on hearsay and anecdotalstories. It is equally important that institutional and retail investors understandwhether or not they are being manipulated or exploited by sophisticated traders,such as HFT.This paper studies HFT from a variety of viewpoints. First, it describes theactivities of HFTs, showing that HFTs make up a large percent of all trading andthat they both provide liquidity and demand liquidity. Their activities tend to bestable over time. Second, it examines HFT strategy and proﬁtability. HFTs gen-erally engage in a price reversal strategy, buying after price declines and sellingafter price gains. They are proﬁtable, making around $3 billion each year on trad-ing volume of $30 trillion dollars traded. Third, it considers the impact of HFTson the market, focusing on three areas - liquidity, price discovery, and volatility.HFTs increase market liquidity: using a variety of Hasbrouck measures, I ﬁnd thatHFTs appear to add to the efﬁciency of the markets. Finally, I ﬁnd that HFTs tendto decrease volatility.
To date, the true cause of the ﬂash crash has not been determined.