Electronic Market Makers, Trader Anonymity and Market Fragility

Abstract

We investigate empirically the impact of electronic market-makers on the reliability and the consistency with which financial markets provide transactional liquidity services. Our analysis is based on proprietary intraday data from U.S. futures markets. We document results of considerable academic and regulatory importance. Using data from 2006 and 2011, we find strong evidence that, in sharp contrast to the erstwhile locals in futures pits, electronic market makers reduce their participation and their liquidity provision in periods of significantly high and persistent volatility, in periods of significantly high and persistent customer order imbalances, and in periods of significantly high and persistent bid ask spreads. The changes in liquidity provision that we observe in an 8-month period around the 2008 Lehman bankruptcy support our main conclusions. Our results are consistent with trader anonymity in electronic markets’ not being conducive to facile adjustment of severe information asymmetries. We also find that electronic market makers with longer trading horizons are much less susceptible to withdrawing from liquidity provision in periods of market stress. Overall, given that electronic market-makers represent the irreversible and inevitable progression of technology, our results raise the question whether exchanges and regulators should consider affirmative obligations for hitherto voluntary market makers.