Intraday Liquidity Provision by Trader Types in a Limit Order Market: Evidence from Taiwan Index Futures

This study examines the dynamic liquidity provision process by institutional and individual traders in the Taiwan index futures market, which is a pure limit order market. The empirical analysis obtains several interesting empirical results. We find that trader type affects liquidity provision in a number of interesting ways. First, although institutional traders use more limit orders than market orders, foreign institution (individual) traders use a relatively higher percentage of market (limit) orders in the early trading session and then switch to more limit (market) orders for the remainder of the day until close to the end of the trading day. Second, net limit order submissions by both institutional and individual traders are positively related to one‐period lagged transitory volatility and negatively related to informational volatility. Third, net limit order submissions by institutional traders are positively related to one‐period lagged spread. Finally, both the state of limit order book and order size significantly influence all types of traders’ strategy on submission of limit order versus market order during the intraday trading session. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 34:145–172, 2014     

Resiliency in the E-mini futures market

We study how quickly liquidity is replenished on the order book in E-mini futures. The results show that participants who use patient methods, such as limit orders, are often fast to place new orders, while those using impatient market orders are slow to re-enter the market. These delays are a function of state constants, such as firm types, state conditions, such as whether the order is price improving, and time-varying covariates, such as the volume of trade during the gap. We also find support for the view that certain traders delay providing liquidity during active markets to avoid informed trading.     

OPTIMAL TRADE EXECUTION AND PRICE MANIPULATION IN ORDER BOOKS WITH TIME‐VARYING LIQUIDITY

In financial markets, liquidity is not constant over time but exhibits strong seasonal patterns. In this paper, we consider a limit order book model that allows for time‐dependent, deterministic depth and resilience of the book and determine optimal portfolio liquidation strategies. In a first model variant, we propose a trading‐dependent spread that increases when market orders are matched against the order book. In this model, no price manipulation occurs and the optimal strategy is of the wait region/buy region type often encountered in singular control problems. In a second model, we assume that there is no spread in the order book. Under this assumption, we find that price manipulation can occur, depending on the model parameters. Even in the absence of classical price manipulation, there may be transaction triggered price manipulation. In specific cases, we can state the optimal strategy in closed form.     

Market structure,liquidity, and information based trading at the Prague Stock Exchange

This paper investigates the relation between liquidity and information based trading and the possible impact of market microstructure changes on this relationship. A model similar in spirit to that of [Easley et al. (1996b) J. Financ. 51(3) (1996) 811–833] is used to determine how often new information occurs and how it influences the composition of orders submitted to the market. There have been several major market structure changes implemented by the Prague Stock Exchange (PSE) over the past 5 years. Thanks to its unique development path, where a given set of stocks were subjected to several changes in trading environment design, PSE trading data can be used to examine how market conditions impact the extent of informed trading and market liquidity.     

Execution quality in open‐outcry futures markets

This study examines the composition of customer order .flow and the execution quality for different types of customer orders in six futures pits of the Chicago Mercantile Exchange (CME). It is shown that off‐exchange customers frequently provide liquidity to other traders by submitting limit orders. The determinants of customers' choice between limit and market orders are examined, and it is found that higher bid—ask spreads increase the limit‐order submission frequency, and increased price volatility makes limit‐order submission less likely. Effective spreads, trading revenues, and turnaround times for customer liquidity‐demanding and limit orders are also documented. Consistent with evidence from equity markets, the results show that limit‐order traders receive better executions than traders using liquidity‐demanding orders, but incur adverse selection costs. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:1067–1092, 2005     

Liquidity supply and volatility: futures market evidence

This article examines the provision of liquidity in futures markets as price volatility changes. We find that customer trading costs do not increase with volatility. However, for three of the four contracts studied, the nature of liquidity supply changes with volatility. Specifically, for relatively inactive contracts, customers as a group trade more with each other and less with market makers, on higher volatility days. By contrast, for the most active contract, trading between customers and market makers increases with volatility. We also find that market makers' income per contract decreases with volatility for one of the least active contracts in our sample, but is not significantly affected by volatility for the other contracts. These results are consistent with the idea that, for high‐cost, inactive contracts, market makers react to temporary increases in volatility by raising their bid‐ask spreads significantly, and customers provide increased liquidity through standing limit orders. An implication of our results is that electronic systems, where market maker participation is not required, are able to supply adequate liquidity during volatile periods. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:1–17, 2001     

OPTIMAL HIGH‐FREQUENCY TRADING IN A PRO RATA MICROSTRUCTURE WITH PREDICTIVE INFORMATION

We propose a framework to study optimal trading policies in a one‐tick pro rata limit order book, as typically arises in short‐term interest rate futures contracts. The high‐frequency trader chooses to post either market orders or limit orders, which are represented, respectively, by impulse controls and regular controls. We discuss the consequences of the two main features of this microstructure: first, the limit orders are only partially executed, and therefore she has no control on the executed quantity. Second, the high‐frequency trader faces the overtrading risk, which is the risk of large variations in her inventory. The consequences of this risk are investigated in the context of optimal liquidation. The optimal trading problem is studied by stochastic control and dynamic programming methods, and we provide the associated numerical resolution procedure and prove its convergence. We propose dimension reduction techniques in several cases of practical interest. We also detail a high‐frequency trading strategy in the case where a (predictive) directional information on the price is available. Each of the resulting strategies is illustrated by numerical tests.     

Liquidity,exchange listing,and common stock performance

The liquidity of securities—the relationship between volume of trading and changes in market price—has won increasing recognition as an element of investment strategy in recent years. Relatively high liquidity is deemed to be a desirable characteristic of a stock, especially for the institutional investor, who typically trades in large volume. Thus, firms can generally be expected to seek means of enhancing the liquidity of their shares. One of the supposed means of accomplishing this is by listing one's stock on a national securities exchange. This paper examines the relationship of common stock liquidity to both exchange listing and price behavior during major up and down movements in the market. Our conceptual and empirical analyses indicate that liquidity is linked to price behavior; and we suggest that the view held by at least some corporate officers—that exchange listing increases liquidity—may be erroneous. More specifically, it appears that when the amount of firm capitalization is taken into account, exchange listing does not result in greater stock liquidity.     

Slow and fast markets

Informed traders need liquidity in order to profit from their private information. Markets provide liquidity and are compensated by the information released through trading. Fast markets provide access to a limit order book. Slow markets provide execution in an auction-based trading floor. Hybrid markets combine both execution venues. It is shown here that the overall efficiency of a hybrid market is determined by its fast component. The introduction of a trading floor does not generate more informed trading, only takes trading away from the fast market. Trading floors are thus inherently competitive to the fast market. We provide conditions that determine the competitiveness of a trading floor with respect to a fast market.     

Sentiment-dependent impact of funding liquidity shocks on futures market liquidity

We examine the effect of funding liquidity changes on futures market liquidity, depending on economic sentiment. Futures market liquidity improves following negative funding liquidity shocks, and economic sentiment is an important determinant explaining this relationship. While individuals' trading is most significantly affected by sentiment, its response to funding liquidity shocks remains independent of sentiment effects. Domestic institutions' reactions depend on the sentiment regime; they trade futures contracts more actively as funding liquidity becomes more abundant (scarcer) when sentiment is more pessimistic (optimistic). Foreigners, following negative funding liquidity shocks, generally increase their futures trading, whereas their trading decreases under the extremely pessimistic sentiment. Domestic banks and pension funds provide liquidity to the futures market even when sentiment is pessimistic.     

RISK METRICS AND FINE TUNING OF HIGH‐FREQUENCY TRADING STRATEGIES

We propose risk metrics to assess the performance of high‐frequency (HF) trading strategies that seek to maximize profits from making the realized spread where the holding period is extremely short (fractions of a second, seconds, or at most minutes). The HF trader maximizes expected terminal wealth and is constrained by both capital and the amount of inventory that she can hold at any time. The risk metrics enable the HF trader to fine tune her strategies by trading off different metrics of inventory risk, which also proxy for capital risk, against expected profits. The dynamics of the midprice of the asset are driven by information flows which are impounded in the midprice by market participants who update their quotes in the limit order book. Furthermore, the midprice also exhibits stochastic jumps as a consequence of the arrival of market orders that have an impact on prices which can give rise to market momentum (expected prices to trend up or down). The HF trader's optimal strategy incorporates a buffer to cover adverse selection costs and manages inventories to maximize the expected gains from market momentum.     

Optimal investment,derivative demand,and arbitrage under price impact

This paper studies the optimal investment problem with random endowment in an inventory‐based price impact model with competitive market makers. Our goal is to analyze how price impact affects optimal policies, as well as both pricing rules and demand schedules for contingent claims. For exponential market makers preferences, we establish two effects due to price impact: constrained trading and nonlinear hedging costs. To the former, wealth processes in the impact model are identified with those in a model without impact, but with constrained trading, where the (random) constraint set is generically neither closed nor convex. Regarding hedging, nonlinear hedging costs motivate the study of arbitrage free prices for the claim. We provide three such notions, which coincide in the frictionless case, but which dramatically differ in the presence of price impact. Additionally, we show arbitrage opportunities, should they arise from claim prices, can be exploited only for limited position sizes, and may be ignored if outweighed by hedging considerations. We also show that arbitrage‐inducing prices may arise endogenously in equilibrium, and that equilibrium positions are inversely proportional to the market makers' representative risk aversion. Therefore, large positions endogenously arise in the limit of either market maker risk neutrality, or a large number of market makers.     

LIQUIDITY IN A BINOMIAL MARKET

We study the binomial version of the illiquid market model introduced by Çetin, Jarrow, and Protter for continuous time and develop efficient numerical methods for its analysis. In particular, we characterize the liquidity premium that results from the model. In Çetin, Jarrow, and Protter, the arbitrage free price of a European option traded in this illiquid market is equal to the classical value. However, the corresponding hedge does not exist and the price is obtained only in L² ‐approximating sense. Çetin, Soner, and Touzi investigated the super‐replication problem using the same supply curve model but under some restrictions on the trading strategies. They showed that the super‐replicating cost differs from the Black–Scholes value of the claim, thus proving the existence of liquidity premium. In this paper, we study the super‐replication problem in discrete time but with no assumptions on the portfolio process. We recover the same liquidity premium as in the continuous‐time limit. This is an independent justification of the restrictions introduced in Çetin, Soner, and Touzi. Moreover, we also propose an algorithm to calculate the option’s price for a binomial market.     

Optimal trade execution in order books with stochastic liquidity

In financial markets, liquidity changes randomly over time. We consider such random variations of the depth of the order book and evaluate their influence on optimal trade execution strategies. If the stochastic structure of liquidity changes satisfies certain conditions, then the unique optimal trading strategy exhibits a conventional structure with a single wait region and a single buy region, and profitable round‐trip strategies do not exist. In other cases, optimal strategies can feature multiple wait regions and optimal trade sizes that can be decreasing in the size of the position to be liquidated. Furthermore, round‐trip strategies can be profitable depending on bid–ask spread assumptions. We illustrate our findings with several examples including the Cox–Ingersoll–Ross model for the evolution of liquidity.     

Order imbalances and market efficiency: New evidence from the Chinese stock market

This paper differentiates order imbalances based on trader categories. The daily order imbalances are highly persistent, especially for the number-measured imbalances. That the price pressure caused by imbalances cannot last beyond a trading day indicates that China's stock market is efficient enough to absorb the imbalances. We find that large individuals, small individuals and small institutions act frequently as market makers by submitting non-marketable limit orders, and the market making activities are profitable for small individuals and institutions. The evidence indicates that individuals are noise or liquidity traders, while institutions are more likely to be informed traders.     

Competition to provide liquidity on the New York Stock Exchange

In order to be successful in attracting trading volume and generate revenue from trading fees, exchanges must allow potential traders to transact quickly at a known price. This is known as providing liquidity. On the New York Stock Exchange, liquidity comes from two sources: traders conducting business on the floor of the exchange and those who electronically send orders to the exchange from off-floor locations. On-floor traders have traditionally been alleged to have advantages over off-floor traders. If that is the case, then this might discourage off-floor traders from providing liquidity and reduce the efficiency of security markets. We find that on-floor traders do seem to enjoy some advantages in providing liquidity, although the differences are not great. This suggests that the New York Stock Exchange is warranted in several of its recent initiatives designed to level the playing field between on- and off-floor traders.     

Institutional Investors,Earnings Quality and Asset Liquidity: Evidence from China’s Stock Market

This paper investigates how institutional holding and earnings quality influence the liquidity of assets. Contrary to findings in developed markets, we document several novel results in China’s stock market: (1) institutional holding negatively affects assets’ liquidity, (2) earnings quality is negatively related with liquidity. Since earnings quality captures asymmetric information, low earnings quality induces high divergence in investor opinions and thus boosts market trading, and (3) interestingly, the effect of earnings quality on liquidity is greater if institutional investors’ holding is at a high level. Overall, our findings cast doubt on the conventional wisdom that institutional investors and earnings quality improve market liquidity. The results are robust to different measures and alternative model specifications.     

The role of floor brokers in the supply of liquidity: An empirical analysis

This article analyses the role of floor brokers in the supply of liquidity on the Australian Stock Exchange Derivatives market. Floor brokers have valuable order execution skills because of their information advantage over off‐floor traders and their ability to mitigate some problems related to the option‐like characteristics of limit orders. Our results indicate that floor broker participation in the execution of limit orders tends to be high when the above qualities are most valuable. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:205–218, 2000     

Portfolio choice with small temporary and transient price impact

We study portfolio selection in a model with both temporary and transient price impact introduced by Garleanu and Pedersen. In the large‐liquidity limit where both frictions are small, we derive explicit formulas for the asymptotically optimal trading rate and the corresponding minimal leading‐order performance loss. We find that the losses are governed by the volatility of the frictionless target strategy, like in models with only temporary price impact. In contrast, the corresponding optimal portfolio not only tracks the frictionless optimizer, but also exploits the displacement of the market price from its unaffected level.     

Optimal make–take fees for market making regulation

We address the mechanism design problem of an exchange setting suitable make– take fees to attract liquidity on its platform. Using a principal–agent approach, we provide the optimal compensation scheme of a market maker in quasi‐explicit form. This contract depends essentially on the market maker inventory trajectory and on the volatility of the asset. We also provide the optimal quotes that should be displayed by the market maker. The simplicity of our formulas allows us to analyze in details the effects of optimal contracting with an exchange, compared to a situation without contract. We show in particular that it improves liquidity and reduces trading costs for investors. We extend our study to an oligopoly of symmetric exchanges and we study the impact of such common agency policy on the system.