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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
  • Mauro Napoletano
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 actorin the post-crash recovery underlies the above trade-off.

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  • Sandrine Jacob Leal & Mauro Napoletano, 2016. "Market Stability vs. Market Resilience: Regulatory Policies Experiments in an Agent Based Model with Low- and High-Frequency Trading," LEM Papers Series 2016/15, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy.
    • Handle: RePEc:ssa:lemwps:2016/15
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    23. Ms. Thornton Matheson, 2011. "Taxing Financial Transactions: Issues and Evidence," IMF Working Papers 2011/054, International Monetary Fund.
    24. Jürgen Huber & Michael Kirchler & Daniel Kleinlercher & Matthias Sutter, 2017. "Market versus Residence Principle: Experimental Evidence on the Effects of a Financial Transaction Tax," Economic Journal, Royal Economic Society, vol. 127(605), pages 610-631, October.
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    More about this item

    Keywords

    High-frequency trading; Flash crashes; Regulatory policies; Agent-based models; Limit order book; Market volatility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G01 - Financial Economics - - General - - - Financial Crises
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques

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