UCLA

The purpose of the financial system is to provide a service to its end-users, savers and investors. It provides a means for savers to earn a return and for investors to obtain funding. For financial intermediaries in contrast, the system's purpose is to provide a revenue source to those who can buy paper at a lower price than they sell it. Financial intermediaries neither intend to promote the interest of savers and investors nor pay special attention to whether they do it. Nevertheless they are the means by which most matches between savers and investors are made. The following chapters explore how the structure of trade---meaning its institutions, practices and technologies---motivates the financial intermediary ``to promote an end which was no part of his intention,'' as Adam Smith wrote. The first chapter studies a common trading institution, the limit-order book, and shows that the conditions for reliable information aggregation are related to the conditions for liquid trade. It is possible that the book's ability to aggregate information breaks down endogenously because participants refuse to trade when they are uncertain and are made uncertain by not trading. The second chapter studies a trading practice, front-running, a strategy of trading on information about future flows of trade. It shows that front-running can generate autocorrelation in prices, or price momentum, and offers an explanation of some asset price volatility in excess of fundamentals. The third chapter studies a trading technology, fast-responding algorithmic trading machines called high-frequency traders. It shows there is some merit to the idea that a technological improvement in trading speeds can be considered an arms race.