Market Design in Fast Markets

Abstract

Financial markets have undergone a dramatic shift in recent years to become highly automated and increasingly fast. Research has begun to demonstrate that the presence of and competition between these new automated participants, often referred to as High Frequency Traders (HFTs), governs market quality outcomes. It is important to understand if the design of markets is appropriate to this dramatic shift in how markets function and whether interventions, or market design responses, can improve market quality. This dissertation demonstrates that market design interventions improve market quality in fast, automated markets in a range of contexts.

First, I demonstrate that the design of a matching engine can create perverse incentives for participants to exaggerate order volumes. I examine such a change by futures exchange LIFFE’s matching engine in 2007, from prioritizing order quantity, to a combination of time priority and quantity. Examining short term interest rate contracts, I show that order volumes normalize and execution quality improves.

Second, I examine the modernization in the London ‘Fix’ benchmark for precious metals which increases transparency. I observe a decline in the fixing duration, a reduction in volatility, return predictability and an improvement in market efficiency in associated futures contracts.

Thirdly, I examine whether markets such as dark pools that rely on reference price feeds, represent market design flaws in the context of fast markets. I document a sizable proportion of dark trades prices which are stale, showing that reference price feeds impose adverse selection costs. I also demonstrate several market design interventions involving random uncrossings, which remove race conditions, improve execution quality and resolve this market design problem.

This dissertation contributes to the recent debate concerning optimal market design in fast, automated markets. This dissertation also provides numerous policy implications for regulators who must respond to increasingly fast markets in accordance with their statutory objectives to ensure market efficiency and integrity.