Broker Colocation, High-Frequency Trading and Institutional Execution Costs

Authors: Satchit Sagade (Goethe University), Stefan Scharnowski (University of Mannheim) and Christian Westheide (University of Vienna)

Title: Broker Colocation, High-Frequency Trading and Institutional Execution Costs

Abstract: We study interactions between large institutional investors and high-frequency trading (HFT) firms in modern equity markets for colocated versus non-colocated brokers when they trade large orders in a proprietary versus agency capacity. Colocated brokers trading on their own account achieve substantially lower transaction costs than non-colocated brokers. However, the beneficial effects of colocation are absent when brokers execute customer trades. While overall HFT activity is harmful for the implementation shortfall of large orders, these effects are restricted to aggressive trading by HFT firms. Colocated brokers, when trading in a proprietary capacity, are able to substantially alleviate these effects. Our results suggest that technologically sophisticated brokers have the capacity to generally achieve superior and consistent execution performance when acquiring large positions. However, their customers do not achieve the same performance even when trading observationally similar orders, either due to a sub-optimal use of the algorithms or due to inferior algorithms being offered by brokers.