The Role of Algorithmic Trading in Stock Liquidity and Commonality in Electronic Limit Order Markets

In investigating the effects of algorithmic trading on stock market liquidity and commonality in liquidity in different market conditions in an electronic limit order market, we find algorithmic trading increases stock liquidity by narrowing quoted and effective bid–ask spreads. Furthermore, algorithmic trading decreases commonality in liquidity; this finding is robust across a variety of liquidity measures. We also find algorithmic trading narrows the quoted and effective spreads to a much lesser extent following extreme market conditions, particularly after large stock market declines. However, the effect of algorithmic trading on commonality in liquidity does not differ following large market declines. Keyword: Algorithmic trading, Liquidity, Commonality in liquidity, Market decline *Authors’ Contact Information: Moriyasu: [email protected], (81)95-820-6375; Wee: [email protected], (61)8-6488-5860; Yu: [email protected], (61)8-64881759. We gratefully acknowledge financial support from the UWA Business School, Faculty of Economics at Nagasaki University and Japan Society for the Promotion of Science. We thank Carole Comerton-Forde, Tony He, Terry Hendershott, Talis Putnis, Tom Smith, Terry Walter, and the seminar participants at the 2013 FMA Asian Conference, the Financial Integrity Research Network Conference and the UWA Business School Accounting&Finance Research Seminar for their helpful comments. This paper was awarded the CFA Institute Research Award at the 2013 FMA Asian Conference in Shanghai. 1 The Role of Algorithmic Trading in Stock Liquidity and Commonality in Electronic Limit Order Markets