HaoxiangZhu

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The dramatic speed of financial transactions can be matched only by the intensity of the controversy surrounding it, especially when it comes to high-frequency trading.

In markets for stocks, futures and foreign exchange, transactions take place in milliseconds to microseconds (or even nanoseconds). Markets for fixed-income securities including corporate bonds and over-the-counter derivatives such as interest-rate swaps are also catching up quickly by adopting electronic trading.

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To many, the “Flash Crash” of May 2010 was a wake-up call for reevaluating market structure. A series of technology glitches proved to be highly costly for some brokers, proprietary firms and marketplaces in terms of both profits and reputation. The SEC launched investigations into HFT firms and their strategies. French regulators introduced a financial transaction tax. Author Michael Lewis wrote “Flash Boys.” The list goes on.

With this fallout comes important economic questions: What are the costs and benefits to investors for speeding up trading? Is there an “optimal” trading frequency at which the financial market should operate? And does a faster market affect one group of investors more than another?

In a recent research paper, “Welfare and Optimal Trading Frequency in Dynamic Double Auctions,” my co-author Prof. Songzi Du (Simon Fraser University) and I attempt to answer these questions.

Our starting point is simple. A higher-frequency market allows investors to access the market more often. When investors meet each other in the market, they trade. Trading can be motivated by new information about future asset value and idiosyncratic trading incentives such as tax or inventory considerations.

A higher-frequency market is more responsive to new information.

A fundamental function of the financial market is to reallocate assets from investors who value them less to investors who value them more, at the right price. The better this function is fulfilled, the more efficient the market is in reallocating the asset.

Higher frequency is a double-edged sword. The optimal trading frequency depends on how the benefit and cost balance each other.

On the bright side, a higher-frequency market is more responsive to new information. Investors benefit from being able to react immediately to news. For example, following earnings announcements or merger-acquisition news, an investor may find his previous allocation on a stock no longer desirable. The sooner investors react to this information by trading, the better off they are. This effect favors a high-frequency market.

On the dark side, a higher-frequency market reduces the aggressiveness of investors’ trades.

Investors are said to be more aggressive if they are willing to tolerate a greater market impact to achieve their target asset position. For example, aggressive execution means trading larger quantities more quickly. By contrast, unaggressive execution means splitting a large order into many small pieces and trading them gradually over time.

The more frequently the market allows investors to transact, the stronger their incentive to split orders over time to avoid price impact; hence, it takes longer to reach desired asset positions, and this is inefficient.

If, however, a market opens infrequently, it encourages investors to trade aggressively — failing to trade now means waiting longer for the next opportunity to trade; this in turn leads to a faster convergence to efficient allocations. In this sense, somewhat counterintuitively, a lower-frequency market enhances allocation efficiency.

Our research shows that the optimal trading frequency depends on the nature of how information arrives, which determines the trade-off between the benefit and cost of higher trading frequency.

For scheduled information, such as earnings announcements and macroeconomic data releases, the optimal trading frequency should be equal to or lower than the frequency of information arrivals. For example, if news only arrives once per day, it is never optimal for investors to trade more than once a day.

For surprise or unplanned news, such as mergers and acquisitions, optimal trading frequency can be much higher. Moreover, if the market is competitive enough, continuous trading (the highest-frequency market) turns out to be optimal.

Accordingly, there is no “one size fits all” optimal trading frequency. Assets such as large-cap stocks or Treasurys that have frequent, unpredictable news should be traded close to continuously. Small, illiquid stocks or bonds that have scarce news may best trade in a low-frequency market that opens only a few times a day.

Haoxiang Zhu is an assistant professor of finance at MIT Sloan School of Management.