Are speed bumps in financial markets accomplishing their goals?

With the prevalence of high-frequency trading, some financial market exchange platforms have imposed speed bumps to delay trading orders and slow these traders down.

“Of course, the details will be different from exchange to exchange, but basically, they slow down or [they] impose some time lags between the order placement by high-frequency traders and order execution,” says Jun Aoyagi, a PhD candidate in economics and finance at the University of California Berkley.

These speed bumps have a positive effect, according to existing research, but a new working paper by Aoyagi showed they may not be as effective as some may think. In fact, the paper found that, in contrast to the intended purpose of the speed bumps, which is to slow high-frequency traders down and protect liquidity providers, they can, in fact, fuel high-frequency traders to invest in high-speed technology.

A speed bump may reduce the bid-ask spread, which high-frequency traders view as an increase in the trading reward, explains Aoyagi. “Basically, facing this larger reward, [the high-frequency trader] — [the] liquidity-taker — is actually more willing to invest in this speed technology to acquire . . . this large reward.”

For long-term investors, on the other hand, speed bumps are a good measure, he notes. “[They are] actually a good thing for those low-speed traders or long-term traders.”

For example, he says introducing a speed bump would increase the frequency of high-frequency traders, which would have negative impacts on short-term liquidity. “But from the point of view of long-term traders, it’s actually good because first, high-frequency traders [are] going to inject more information into the market, meaning that [the] price discovery process is going to be facilitated because of this high-frequency trading. And from the point of view of long-term agents, it’s actually a good thing because the price is going to reflect more precise information about the true value of the assets.”

In particular, the paper found the cost of speed, expected length of a speed bump and the assets’ volatility all impact its effectiveness.

Overall, speed bumps can impact the aggregate welfare in different ways and one design for a speed bump won’t fit all situations. Plus, there may be a way to optimally design speed bumps, Aoyagi notes.

The paper was presented at the Northern Finance Association’s 2020 conference. The Canadian Investment Review is a proud partner of the NFA conference.