Who Supplies Liquidity, How and When?
34 Pages Posted: 7 Jun 2016
Date Written: May 2016
Who provides liquidity in modern, electronic limit order book, markets? While agency trading can be constrained by conflicts of interest and information asymmetry between customers and traders, prop traders are likely to be less constrained and thus better positioned to carry inventory risk. Moreover, while slow traders' limit orders may be exposed to severe adverse selection, fast trading technology can improve traders' ability to monitor the market and avoid being picked off. To shed light on these points, we rely on unique data from Euronext and the AMF, the French financial markets regulator, enabling us to observe the connectivity of traders to the market, and whether they are proprietary traders. We find that proprietary traders, be they fast or slow, provide liquidity with contrarian marketable orders, thus helping the market absorb shocks, even during a crisis, and they earn profits while doing so. Moreover, fast traders provide liquidity by leaving limit orders in the book. Yet, only prop traders can do so without making losses. This suggests that technology is not enough to overcome adverse selection; monitoring incentives are also needed.
Keywords: Liquidity, high-frequency trading, proprietary trading, adverse selection, electronic limit order book, short-term momentum, contrarian
JEL Classification: D82, D53, G01
Suggested Citation: Suggested Citation