An empirical analysis of the supply of liquidity by locals in futures markets: evidence from the Sydney futures exchange

Abstract

In direct contradiction to received theoretical inventory control models, this study provides direct evidence that locals on the Sydney Futures Exchange do not participate exclusively as passive market participants In fact, rather than act purely as market makers, locals as a group are almost as likely to demand liquidity as supply it. The study then documents the market conditions under which locals are more likely to supply liquidity. It is found that when locals trade on the floor, they tend to supply liquidity when the spread is narrow, trading activity and volatility low, at the close and demand liquidity during information periods. As such, locals provide liquidity when it is least valuable. The study also finds that the characteristics of locals that supply liquidity are not consistent with the definition of a scalper assumed by previous literature. Specifically, locals are more likely to be suppliers of liquidity if they do not exhibit zero inventory positions at day end, they undertake relatively few trades, and their trades are infrequent However, consistent with scalper behaviour, local trades arc typically smaller when liquidity is supplied for the interest rate contracts on the floor.