Eric Budish, associate professor of economics at the University of Chicago Booth School of Business, and John J. Shim, a Chicago Booth Ph.D. student, with Peter Cramton of the University of Maryland, have won the 2014 AQR Insight Award for their research on high-frequency trading.
Awarded by AQR Capital Management since 2012, the Insight Award recognizes "important, unpublished papers that provide the most significant, new practical insights for tax-exempt institutional or taxable investor portfolios."
"I'm honored and humbled by the award, and excited for the work that lies ahead," Budish said. "It's especially gratifying for our research to be recognized by AQR, a firm with such deep expertise on market structure issues, and with such a deep commitment to academic research."
Budish, Shim and Cramton received the award for what AQR describes as their "path-breaking" paper, "The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response," a body of research that recently was lauded in a speech by New York Attorney General Eric T. Schneiderman as "a detailed and thoughtful proposal for reforms that would fundamentally reorient the markets in a very simple way that would help restore confidence in them. Their proposals would reaffirm the basic concept that the best price — not the highest speed — should win."
AQR Founding Principal David G. Kabiller says, "While AQR does not endorse any specific policy implications of the research, we do believe this paper is an important step to formalizing the study of alternative designs."
In the paper, Budish, Shim and Cramton argue that virtually instantaneous continuous trading has led to an "arms race" in which traders try to shave ever-smaller fractions of a second off execution speeds. However, since prices for related financial products (such as S&P 500 exchange traded funds, traded in New York, and the corresponding futures contracts, traded in Chicago) cannot change at exactly the same time, a brief price discrepancy opens up arbitrage opportunities that reward the fastest traders, fueling the need for more and more speedy trading.
This "high-frequency trading arms race," the authors show, is a never-ending, equilibrium feature of the market design that is wasteful and harms liquidity.
Budish, Shim and Cramton propose to replace continuous trading with "frequent batch auctions" — auctions at predetermined time intervals, such as once every second or 100 milliseconds. The auctions, they write, would stop the arms race and enhance liquidity by transforming competition on speed into competition on price.
"We are not nostalgic for the era of human-based trading. The empirical record is clear that information technology has significantly enhanced the performance of our financial markets," Budish says. "But it is important to distinguish between IT overall and the speed race. Algorithmic trading firms would continue to play a critical role in financial markets under discrete-time trading, but without the harmful and potentially destabilizing speed race."
Budish is the second Booth faculty member to win the award, following Bryan Kelly, who won the inaugural award in 2012 for "Market Expectations in the Cross Section of Present Values." Amit Seru won the Distinguished Paper Award in 2013 for "Asset Quality Misrepresentation by Financial Intermediaries: Evidence from the Residential Mortgage-backed Securities Market."