Who Makes Markets? Liquidity Providers Versus Algorithmic Traders

Abstract

We investigate the roles of liquidity providers (LPs) and algorithmic traders (ATs) using a complete derivative warrant trading record of all investors in Korea. The main empirical findings indicate that LPs, the sole traders responsible for making market, do not trade primarily for liquidity provision. Instead, ATs provide liquidity. We further study the profitability of LPs and ATs and decompose their profits into information, market making, and mixed components. The results provide strong evidence that LPs earn profits using information about the future prospects of derivative warrants. ATs, however, are much better at sustaining profits by providing liquidity. Surprisingly, our evidence shows that though LPs earn positive total profits, ATs generally incur losses by trading. (c) 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:397-420, 2013