Liquidity in an Automated Auction

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Abstract
The use of automated auctions to trade equities, derivatives, bonds and foreign exchange has increased dramatically in recent years. Trading in automated auctions occurs through an electronic limit order book without the need for dealers. Automated auctions offer advantages of speed and simplicity, but depend on public limit orders for liquidity. To the extent that liquidity varies over time, it affects trading costs, volatility, and induces strategic behavior by traders. Time variation in liquidity is also of considerable importance because liquidity affects expected returns. This paper uses data from an automated futures market to analyze the dynamic relation between market liquidity, returns, and volatility. Several new results emerge. We document wide intertemporal variation in aggregate market liquidity, measured by the depth of the limit order book at a point in time. Discretionary traders trade in high liquidity periods, reinforcing the concentration of volume and liquidity at certain points in time. Our results are consistent with models where liquidity is a factor in expected returns, but also suggest more complicated dynamics consonant with supply and demand imbalances in the market. While increases in liquidity substantially reduce volatility, volatility shocks reduce liquidity over the short-run, impairing price efficiency. These effects dissipate quickly, however, and their magnitudes are small, indicating a high degree of market resiliency.