Who Supplies Liquidity, and When?
63 Pages Posted: 15 Aug 2018
Date Written: August 14, 2018
We incorporate discrete tick size and allow non-high-frequency traders (non-HFTs) to supply liquidity in the framework of Budish, Cramton, and Shim (2015). When adverse selection risk is low or tick size is large, the bid-ask spread is typically below one tick, and HFTs dominate liquidity supply. In other situations, non-HFTs dominate liquidity supply by undercutting HFTs, because supplying liquidity to HFTs is always less costly than demanding liquidity from HFTs. A small tick size improves liquidity, but also leads to more mini-flash crashes. The cancellation-to-trade ratio, a popular proxy for HFTs, can have a negative correlation with HFTs’ activity. Our model provides one explanation of flash crashes, and predicts when and where flash crashes are more likely to occur.
JEL Classification: G10, G20
Suggested Citation: Suggested Citation