Disappearing Liquidity: Why It Matters and How to Deal with It

Abstract

We address the concerns surrounding fast-disappearing liquidity and its effects on both the market and the order placement behavior of slow traders. We find that in response to an increase in short-lived cancellations, slow traders submit fewer and less aggressive orders, thus being at a disadvantage. Nevertheless, our results show that both fast and slow cancellations have a positive effect on the market overall, reducing spread and price volatility, and increasing depth. Since we do not advocate limiting fast cancellations, we develop a framework that allows traders to differentiate between a firm and a phantom quote with 67% success, thus increasing the fill rate of their orders.

Keywords: NASDAQ, ITCH, algorithmic trading, order cancellations, liquidity provision, market quality, phantom liquidity

JEL Classification: G10, G14, G18, G40