Liquidity Providers on an Electronic Order-Driven Market

Abstract

The Taiwan Stock Exchange (TSEC) is an electronic order-driven market without designated market makers. By turnover rate the TSEC is the most liquid market in the world. This paper is about the liquidity providers on the TSEC. Our analysis sheds light on the design of trading mechanism of an order driven market that fosters liquidity providing behavior of its participants. We identify institutional traders such as depository institutions, corporations, insurance companies, and investment companies as viable liquidity providers. They trade heavily, make handsome profits, and their trading profits increase with trading volume as well as the frequency of participation in trades. They have some timing and securities selection ability. They use limit orders extensively and mix limit and market orders in their trading strategy. However, they provide less than 4% of the liquidity on the TSEC. The bulk of the liquidity on the TSEC is provided by individual investors who use limit orders extensively. Our analysis indicates that the TSEC can be characterized as a market where every participant has a good chance of making short-term capital gains. Very few viable liquidity providers make persistent profits. The transaction cost on the TSEC is low. There is no equity requirement for submitting orders. The market is fair in the sense that every trader has the same trade information and trade access.