Inefficiency in Frequent Batch Auctions with Privately Informed Trading
Authors: Steffen Eibelshäuser (Goethe University)
Title: Inefficiency in Frequent Batch Auctions with Privately Informed Trading
Abstract: Continuous limit order book markets, the currently predominant trading mechanism on financial exchanges, facilitate cross-market arbitrage and impose adverse selection risk on liquidity providers. Furthermore, they induce an arms race for speed technology because the fastest traders earn all arbitrage rents. In order to mitigate arbitrage and to overcome the arms race, it has been suggested to slow markets down and to conduct trade at discrete points in time rather than continuously. In this paper, I explore the welfare effects of discrete trading using a simple trading model with privately informed traders and noise traders. Slowing markets down does not necessarily improve liquidity. If securities were traded in discrete batch auctions, liquidity providers could not continuously monitor the order flow and update their quotes accordingly. As a result, similar to standard multi-unit auctions, every equilibrium in the batch auction is inefficient. The inefficiency associated with batch auction trading can outweigh the benefits from reduced arbitrage, eventually reducing liquidity and harming investors.