We examine the role of short and long term traders in liquidity provision during normal times and during crashes in the spot market for stocks using a unique dataset that has trader identities. The dataset consists of orders and trades in the shares of a single actively traded firm on the National Stock Exchange of India from April to June 2006 when 116 million shares with a combined market value of 100Bn Rupees changed hands. Short term traders who carried little or no inventories overnight were important providers of liquidity and they were on one side of over 75% of the shares traded. We find that during normal times liquidity providers managed their inventory risk through hot potato trading, hedging using futures, and order modifications. During normal price fluctuations short term traders put in buy orders when prices declined and sold when prices rose thereby providing liquidity to the market. However, during the two fast crash days in our sample when prices declined and then recovered by more than 3% within a 15 minute interval, their buying was not enough to meet the liquidity needs of foreign institutions who sold into the crashes. Inventories of short term traders were high preceding the two crashes, indicating limited capital capacity and therefore market fragility. Buying by domestic mutual funds, which have a natural advantage in making a market in the basket of stocks they hold, led to price recoveries, highlighting the stabilizing role of slow moving market making capital in fast crashes.
|Original language||English (US)|
|Number of pages||65|
|State||Published - Apr 8 2014|