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Who Makes Markets? Liquidity Providers Versus Algorithmic Traders

Authors

  • Joon Chae,

    1. Joon Chae is an Associate Professor of Finance, Graduate School of Business, Seoul National University, Seoul, Korea
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  • Jaeuk Khil,

    1. Jaeuk Khil is a Professor of Finance, Department of Business Administration, Hanyang University, Ansan, Korea
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  • Eun Jung Lee

    Corresponding author
    1. Eun Jung Lee is an Assistant Professor of Finance, Department of Business Administration, Hanyang University, Ansan, Korea
    • Joon Chae is an Associate Professor of Finance, Graduate School of Business, Seoul National University, Seoul, Korea
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  • We are grateful for comments and suggestions from an anonymous referee and the editor (Bob Webb). This work was supported by the research fund of Hanyang University (HY-2009-N).

Correspondence author, 1271 Sa 3-dong, Sangrok-Gu, Ansan, Gyeonggi-Do, 426-791, Korea. Tel: +82-31-400-5645, Fax: +82-31-436-8180, e-mail: ejunglee@hanyang.ac.kr

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. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:397-420, 2013

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