Liquidity provision, commonality and high frequency trading
Authors: Panagiotis Anagnostidis (Institut Europlace de Finance (IEF) and European Financial Data Institute (EUROFIDAI)) and Patrice Fontaine (European Financial Data Institute (EUROFIDAI), CNRS and Léonard de Vinci Pôle Universitaire, Research Center)
Title: Liquidity provision, commonality and high frequency trading
Abstract: We investigate the role of high frequency traders (HFTs) in the formation of market-wide systematic (il)liquidity movements in the Euronext Paris low latency trading platform. The related microstructure literature has focused more on the effect of HFT algorithms on firm-specific liquidity, whereas there is little evidence on the role of HFTs in the formation of market-wide (il)liquidity risk. We find that HFT quotes lead, by far, the liquidity supply process, being responsible for almost 90% of total available shares up to the best 10 bid/ask limits of the order book. Based on the estimation of the liquidity factor model of Chordia et al. (2000) and a subsequent, corroborating, principal component analysis, our results indicate that HFTs contribute significantly to the formation of systemic liquidity risk. Commonality is weak at the prevailing bid/ask limits, whereas it increases sharply deeper in the order book. Consequently, small investors face less liquidity risk compared to large traders. Also, commonality is asynchronous suggesting that traders should consider timing more promptly in their biding strategies.