Algorithmic Trading and the Market for Liquidity

TLDR

Algorithmic trading has become a significant component of market activity since 2008. The study investigates how algorithmic traders influence liquidity supply and demand in 30 DAX stocks on the Deutsche Börse in January. Algorithmic traders account for 52 % of market order volume and 64 % of nonmarketable limit order volume, actively monitor liquidity, consume it when spreads are narrow and supply it when spreads are wide, and react more quickly to market events, especially with wide spreads.

Abstract

Abstract We examine the role of algorithmic traders (ATs) in liquidity supply and demand in the 30 Deutscher Aktien Index stocks on the Deutsche Boerse in Jan. 2008. ATs represent 52% of market order volume and 64% of nonmarketable limit order volume. ATs more actively monitor market liquidity than human traders. ATs consume liquidity when it is cheap (i.e., when the bid-ask quotes are narrow) and supply liquidity when it is expensive. When spreads are narrow ATs are less likely to submit new orders, less likely to cancel their orders, and more likely to initiate trades. ATs react more quickly to events and even more so when spreads are wide.