Measuring and Explaining Liquidity on an Electronic Limit Order Book: Evidence from Reuters D2000-2

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Abstract
This paper is an empirical examination of liquidity determination on an electronic FX broking system. We focus on two facets of liquidity. First we study the dynamics of liquidity supply and demand via event-time order arrival probabilities and calendar-time order entry rates. We demonstrate that the order book is "dynamically illiquid" as subsequent to market order arrival further liquidity is removed from the system. We also show that the proportion of limit orders in order flow increases with volatility. Second we investigate determination of order book depth. We show that, after controlling for repetitive intra-day patterns, buy and sell side depth are uncorrelated. We also find that depth is negatively related to volatility and unexpected volume but positively related to expected volume. These results suggest that liquidity suppliers are risk-averse and are concerned with the possibility of informed trade.