When do informed traders provide liquidity?
41 Pages Posted: 20 Aug 2013 Last revised: 24 Jan 2019
Date Written: January 21, 2018
With the demise of traditional market makers and proliferation of trade execution algorithms that mix market and limit orders, it is no longer clear who provides liquidity in limit order book markets and what determines their liquidity provision decisions. To examine these issues, we develop and validate two empirical measures of informed traders’ order choice. We find that informed traders tend to provide liquidity with limit orders during periods of high uncertainty about the fundamental value (high volatility, wide spreads). At such times, mispricing persists for longer so the informed trade more patiently to obtain better execution prices. Price discovery is slower when informed traders use limit orders and consequently their order choice acts as an uncertainty multiplier.
Keywords: liquidity, price discovery, informed trading, limit order, market order
JEL Classification: G14
Suggested Citation: Suggested Citation