Do Proprietary Algorithmic Traders Withdraw Liquidity During Market Stress?

Abstract

We investigate the role of proprietary algorithmic traders (PAT) in facilitating liquidity in a limit order market. Using the order level data from NSE of India, we find that they increase limit order supply following periods of high short-term stock-specific volatility, periods of high short-term market-wide volatility and periods of extreme stock price movement. We define orders from HFT as a subclass of orders from PAT which are revised in less than three milliseconds. The behaviour of HFT mimics the behaviour of its parent class. This is inconsistent with the theory that fast traders leave the market when stress situations arise, although their limit order supplying behaviour becomes neutral when short-term volatility is more informational than transitory. The agency algorithmic traders (AAT) and non algorithmic traders (NAT) behave opposite to PAT by reducing the supply of liquidity during stress situations. The presence of faster traders in the market possibly instils the fear of adverse selection in them. We document that order imbalance of AAT is found to be related to short-term returns, while order imbalance of PAT is not related to short-term returns.