Who Provides Liquidity and When?
Finance Down Under 2018 Building on the Best from the Cellars of Finance Paper
64 Pages Posted: 21 Jan 2017 Last revised: 18 Jul 2019
Date Written: January 1, 2019
We model competition for liquidity provision between high-frequency traders (HFTs) and slower execution algorithms designed to minimize transaction costs for buy-side institutions (B-Algos). Under continuous pricing, B-Algos dominate liquidity provision by using aggressive limit orders to stimulate HFTs’ market orders. Under discrete pricing, HFTs dominate liquidity provision if the bid–ask spread is binding at one tick. If the tick size is not binding, B-Algos choose between stimulating HFTs and providing liquidity to other non-HFTs. Flash crashes arise under certain parameter values. Transaction costs can be negatively correlated with the bid–ask spread when all traders can provide liquidity.
Keywords: Algorithmic trading, High-frequency trading, Liquidity, Tick Size
JEL Classification: G10, G20
Suggested Citation: Suggested Citation