Understanding the Stakes of High-Frequency Trading.

Summary Recent regulatory changes, known as Reg NMS in the United States or MiFID in Europe, together with the effects of the financial crisis (mainly its impact on liquidity), induced major changes on market microstructure in two main aspects: • the fragmentation of the liquidity around several trading venues, with the appearance of newcomers in Europe like Chi-X, BATS Europe, or Turquoise, some of them being not regulated or “dark". • the rise of a new type of agents, the high frequency traders, liable for 40% to 70% of the transactions. These two effects are linked since the high frequency traders, being the main clients of the trading venues, have an implicit impact on the products offered by these venues. Combining a survey of recent academic findings and empirical evidences, this paper presents what we consider to be the key elements to understand the stakes of these changes, and also provides potential clues to mitigate some of them. A first section is dedicated to exposes the recent modifications in market microstructure. The second one explains the role of the price formation process and how, interacting with liquidity supply and demand, high frequency traders can reshape it. The next section discloses the various strategies used by these new market participants and their profitability. A final section discusses recent tools designed in order to assess and control the high frequency trading activity.