2016/15 | LEM Working Paper Series | ||||||||||||||||
Market Stability vs. Market Resilience: Regulatory Policies Experiments in an Agent Based Model with Low- and High-Frequency Trading |
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Sandrine Jacob Leal and Mauro Napoletano |
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Keywords | |||||||||||||||||
High-frequency trading, Flash crashes, Regulatory policies, Agent-based models, Limit order book, Market volatility
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JEL Classifications | |||||||||||||||||
G12, G01, C63
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Abstract | |||||||||||||||||
We investigate the effects of different regulatory policies directed
towards high-frequency trading (HFT) through an agent-based model of a
limit order book able to generate flash crashes as the result of the
interactions between low- and high-frequency (HF) traders. We analyze
the impact of the imposition of minimum resting times, of circuit
breakers (both ex-post and ex-ante types), of cancellation fees and of
transaction taxes on asset price volatility and on the occurrence and
duration of flash crashes. In the model, low-frequency agents adopt
trading rules based on chronological time and can switch between
fundamentalist and chartist strategies. In contrast, high-frequency
traders activation is event-driven and depends on price
fluctuations. In addition, high-frequency traders employ low-latency
directional strategies that exploit market information and they can
cancel their orders depending on expected profits. Monte-Carlo
simulations reveal that reducing HF order cancellation, via minimum
resting times or cancellation fees, or discouraging HFT via financial
transaction taxes, reduces market volatility and the frequency of
flash crashes. However, these policies also imply a longer duration of
flash crashes. Furthermore, the introduction of an ex-ante circuit
breaker markedly reduces price volatility and removes flash
crashes. In contrast, ex-post circuit breakers do not affect market
volatility and they increase the duration of flash crashes. Our
results show that HFT-targeted policies face a trade-off between
market stability and resilience. Policies that reduce volatility and
the incidence of flash crashes also imply a reduced ability of the
market to quickly recover from a crash. The dual role of HFT, as both
a cause of the flash crash and a fundamental actor in the post-crash
recovery underlies the above trade-off.
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