Adrian, Tobias Capponi, Agostino Vogt, Erik Zhang, Hongzhong
Staff Report No. 799
The share of market making conducted by high-frequency trading (HFT) firms has been rising steadily. A distinguishing feature of HFTs is that they trade intraday, ending the day flat. To shed light on the economics of HFTs, and in a departure from existing market-making theories, we model an HFT that has access to unlimited leverage intraday but must fund any end-of-day inventory at an exogenously determined cost. Even though the inventory costs occur only at the end of the day, they impact intraday price and liquidity dynamics. This gives rise to an intraday endogenous price impact mechanism. As the end of the trading day approaches, the sensitivity of prices to inventory levels intensifies, making price impact stronger and widening bid-ask spreads. Moreover, imbalances of buy and sell orders may catalyze hikes and drops in prices, even under fixed supply and demand functions. Empirically, we show that these predictions are borne out in the U.S. Treasury market, where bid-ask spreads and price impact tend to rise toward the end of the day. Furthermore, price movements are negatively correlated with changes in inventory levels as measured by the cumulative net trading volume.