Algorithmic Trading and Market Microstructure: Liquidity,
Volatility, and Price Discovery
Prof. Marco Bianchi, Dr. Sophie Laurent, Dr. Raj Patel
Centre for Financial Markets Research, London School of Finance
March 2026
Abstract
This paper investigates the microstructure effects of algorithmic and high-frequency trading
(HFT) on equity market quality, using a comprehensive dataset of order-level trade data from six
major exchanges over 2019–2024. We find that HFT activity improves quoted liquidity—
reducing bid-ask spreads by an average of 23 basis points—but simultaneously increases
realized short-run volatility by 8.4% and accelerates price discovery. The liquidity benefits are
concentrated during normal market conditions, whereas HFT participation declines sharply
during stress events, amplifying liquidity dry-ups. We propose a taxonomy of HFT strategies and
document differential effects by strategy type, with market-making algorithms providing stable
benefits and latency arbitrage strategies contributing disproportionately to volatility.
1. Introduction
The proliferation of algorithmic and high-frequency trading has fundamentally transformed the
structure of modern financial markets. By 2024, algorithmic trading accounted for approximately
70–80% of equity market volume in the United States and 50–65% in European markets. This
transformation has ignited debate about whether technological advancement in trading serves
the broader market efficiency objective or primarily redistributes rents among sophisticated
participants.
We contribute to this debate by providing comprehensive empirical evidence on the causal
effects of HFT participation on three dimensions of market quality: liquidity, volatility, and price
discovery. Crucially, we distinguish between HFT strategies—separating market-making from
directional and latency arbitrage approaches—as theory predicts that these strategies have
opposing effects on market quality.
Algorithmic Trading and Market Microstructure: Liquidity, Volatility, and Price Discovery | Page 1
2. Conceptual Framework
We build on the theoretical work of Budish, Cramton, and Shim (2015), who model HFT as a
continuous-time arms race that generates social waste while providing only transient liquidity
benefits. Against this, Brogaard, Hendershott, and Riordan (2014) argue empirically that HFT
contributes to price discovery by trading in the direction of permanent price changes. We
reconcile these views by arguing that the net effect depends critically on market conditions and
HFT strategy composition.
Our framework predicts that during calm markets, market-making HFT algorithms face low
adverse selection and thus provide tight spreads profitably. During stress episodes, however,
adverse selection risk spikes, leading to rapid withdrawal of HFT liquidity. This procyclical
behavior implies that HFT may contribute to flash crash dynamics even while improving average
market quality.
3. Data and Identification
We utilize a proprietary dataset of timestamped order book messages (additions, cancellations,
and trades) from NASDAQ, NYSE, LSE, Deutsche Börse, Euronext Paris, and Tokyo Stock
Exchange over January 2019 to December 2024, comprising over 2.4 trillion order events. HFT
firms are identified using the methodology of Hagstromer and Norden (2013), supplemented by
co-location server assignment data obtained under regulatory access agreements.
Causal identification leverages exchange-specific co-location capacity constraints and fee
schedule changes as instruments for HFT participation intensity. We implement a regression
discontinuity design around HFT fee thresholds and a shift-share instrument that interacts
national co-location roll-out timing with pre-existing latency infrastructure quality.
4. Results
An increase of one standard deviation in HFT market share is associated with a 23.1 basis point
reduction in effective bid-ask spreads and a 15.4% increase in market depth at the best quotes.
These liquidity improvements benefit institutional and retail traders equally in normal conditions.
However, the same increase in HFT participation raises 5-minute realized volatility by 8.4%,
consistent with faster but noisier price discovery.
Our strategy-level analysis reveals significant heterogeneity: market-making HFT improves
spreads without increasing volatility, while latency arbitrage accounts for 62% of the aggregate
volatility increase. During the 12 largest intraday stress events in our sample, HFT market-
making participation fell by 47% within the first 90 seconds, creating acute liquidity gaps
subsequently filled by slower, traditional market makers at substantially worse prices.
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Table 1: Microstructure Effects by HFT Strategy Type
HFT Strategy Spread Volatility Effect Price Discovery Stress
Reduction (bps) (%) (%) Withdrawal (%)
Market Making -18.4*** +1.2 +22.1*** 31.4
Statistical -6.2** +3.8* +15.6*** 44.8
Arbitrage
Latency Arbitrage +1.5 +12.9*** +8.3** 72.6
Directional/ -3.1* +6.4** +11.4*** 58.2
Momentum
All HFT -23.1*** +8.4*** +18.9*** 47.3
Combined
Conclusion
This research contributes to the growing body of literature in business and finance, offering
actionable insights for practitioners, policymakers, and scholars. Future work should further
explore the long-term implications of the findings presented herein, particularly in light of
evolving global market conditions and regulatory landscapes.
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