(Very Good) Paper by Thierry Foucault, Ohad Kadan, and Eugene Kandel
We develop a model of trading in securities markets with two specialized sides: traders posting quotes (market makers) and traders hitting quotes (market takers). Liquidity cycles emerge naturally, as the market moves from phases with high liquidity to phases with low liquidity. Traders monitor the market to seize profi t opportunities. Complementarities in monitoring decisions generate multiplicity of equilibria: one with high liquidity and another with no liquidity.
The trading rate depends on the allocation of the trading fee between each side and the maximal trading rate is typically achieved with asymmetric fees. The difference in the fee charged on market-makers and the fee charged on market-takers (the make-take spread) increases in (i) the tick-size, (ii) the ratio of the size of the market-making side to the size of the market-taking side, and (iii) the ratio of monitoring costs for market-takers to monitoring costs for market-makers. The model yields several empirical implications regarding the trading rate, the duration between quotes and trades, the bid-ask spread, and the effect of algorithmic trading on these variables.
I read it as a confirmation that HFT is benign, monitoring (by market-makers) has a cost but it’s lower when done electronically and the maker/taker model does result in lower bid/asked spreads on balance at least for “normal” sized orders. Basically there is less friction because the trading platforms try to maximize the trading rate and they do that by differencing prices for makers and takers, and with less friction the net results is lower costs on balance for end-users.
you’ve read the paper… I’m just starting to read it… in your opinion, how does it affect the current HFT debate, which I don’t have a strong opinion on yet?