Man vs. Machine: Liquidity Provision and Market Fragility

47 Pages Posted: 2 Feb 2021

See all articles by Vikas Raman

Vikas Raman

Lancaster University - Department of Accounting and Finance

Michel A. Robe

University of Illinois at Urbana-Champaign

Pradeep K. Yadav

University of Oklahoma Price College of Business

Date Written: January 13, 2020

Abstract

We empirically investigate the participation and transactional liquidity provided by algorithmic vs. human traders during “abnormally” stressful periods, relative to what they do in “normal” periods, and the resultant implications for the quality and fragility of markets. We find strong evidence that, in periods of abnormal stress, algorithmic traders significantly reduce their participation and liquidity provision in trades; significantly reduce the extent to which they post new liquidity-supplying limit orders; significantly reduce the aggressiveness of these limit orders, and sharply increase the price at which they are willing to supply liquidity. We define abnormal stress based on persistently extreme levels of volatility, order-imbalances, and bid-offer spreads; and measures that proxy for “ambiguity” or complexity. This significantly greater withdrawal of algorithmic (relative to human) traders is directly associated with the disappearance of information advantages of algorithmic traders. We find that this has a significant propensity to generate feedback loops, and induce “contagion” through withdrawals in liquidity provision in related stocks, potentially making markets more “fragile”. Our results suggest that, in contrast to manual traders who adapt in (higher latency) real time, algorithmic trade execution appears less conducive to low impact adjustment of ambiguous information asymmetries or flows. Overall, our results reinforce regulatory concerns about the potential for systemic fragility in markets dominated by machine-based liquidity provision.

Keywords: Voluntary market-making, Algorithmic traders, Liquidity, Fragility

JEL Classification: G10, G14, G18

Suggested Citation

Raman, Vikas and Robe, Michel A. and Yadav, Pradeep K., Man vs. Machine: Liquidity Provision and Market Fragility (January 13, 2020). Available at SSRN: https://ssrn.com/abstract=3757848 or http://dx.doi.org/10.2139/ssrn.3757848

Vikas Raman

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom

Michel A. Robe

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Pradeep K. Yadav (Contact Author)

University of Oklahoma Price College of Business ( email )

307 W.Brooks, Room 205A Division of Finance
Norman, OK 73019
United States
4053256640 (Phone)
4053255491 (Fax)

HOME PAGE: http://www.ou.edu/price/finance/faculty/pradeep_yadav.html

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