Abstract

We construct a financial market model in which high frequency traders post limit orders to compete for market making. We show that the high frequency traders may give up liquidity provision due to competition if the price volatility is high. However, the depletion of liquidity can be avoided if they are allowed to cancel their orders. The above finding as well as others leads to an important policy implication that the cancellation strategy, which is one of the most prominent characteristics of high frequency trading, positively affects the market liquidity and should not be strictly regulated.