“Toxic Arbitrage”, with Roman Kozhan and Wing Wah Tham. Review of Financial Studies 30, 1053-1094, 2017.
Evidence that high speed arbitrage can raise illiquidity by exposing liquidity suppliers to the risk of trading at stale quotes .
Latest draft available (SSRN)
An executive summary of our paper published in the Center for the Study of Financial Regulation
Abstract: Short lived arbitrage opportunities arise when prices adjust with a lag to new information. They are toxic because they expose dealers to the risk of trading at stale quotes. Hence, theory implies that more frequent toxic arbitrage opportunities and a faster arbitrageurs’ response to these should impair liquidity. We provide supporting evidence using data on triangular arbitrage. As predicted, illiquidity is higher on days when the fraction of toxic arbitrage opportunities and arbitrageurs’ relative speed are higher. Overall, our findings suggest that the price efficiency gain of high frequency arbitrage comes at the cost of increased adverse selection risk.
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