Market Liquidity: A Study from Proprietary Algorithmic Traders Perspective

Abstract

In this paper, we investigate the role of proprietary algorithmic traders in facilitating liquidity in a limit order market. Using the order level data from National Stock Exchange of India, we find that they increase limit order supply following periods of high short-term volatility or periods of extreme stock movement. We define HFT as a subclass of proprietary algorithmic traders who uses very low latency. The behaviour of HFT mimics the behaviour of its parent class. This is inconsistent with the theory that fast traders leave the market when stress situations arise, although their limit order supplying behaviour becomes neutral when short-term volatility is more informational than transactional. The agency algorithmic traders behave opposite to proprietary algorithmic traders by reducing supply of liquidity during stress situations. We also document that order imbalance of agency algorithmic traders is found to affect short-term returns, while order imbalance of proprietary algorithmic traders is related to short-term returns in a much lesser capacity.

Keywords: HFT, depth, cancellation, volatility, limit orders, stress

JEL Classification: G10, G14, G18, G19