Does Algorithmic Trading Improve Liquidity?

  • Author(s): TERRENCE HENDERSHOTT, CHARLES M. JONES, ALBERT J. MENKVELD
  • Published: Jan 06, 2011
  • Pages: 1-33
  • DOI: 10.1111/j.1540-6261.2010.01624.x

ABSTRACT

Algorithmic trading (AT) has increased sharply over the past decade. Does it improve market quality, and should it be encouraged? We provide the first analysis of this question. The New York Stock Exchange automated quote dissemination in 2003, and we use this change in market structure that increases AT as an exogenous instrument to measure the causal effect of AT on liquidity. For large stocks in particular, AT narrows spreads, reduces adverse selection, and reduces trade‐related price discovery. The findings indicate that AT improves liquidity and enhances the informativeness of quotes.

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