Active Traders, Capital and Liquidity

Understanding the determinants of liquidity is fundamentally important for both asset pricing and market design. I investigate how changes in the capital position of speculators affect their willingness to provide liquidity, and the extent to which capital shocks affect time-varying aggregate liquidity. I analyze the entire transaction histories of all participants on the main exchange for agricultural commodity futures in India over a period of four years. Furthermore, I solve the standard identification problem by exploiting exogenous variation in speculators ’ capital in the form of losses in one market unrelated to the fundamentals of another market. My findings are as follows. First, a small number of traders accounts for an overwhelming share of trading activity and participate in the market for a large number of commodities. Second, some evidence exists suggesting that capital position affects liquidity provision and market liquidity, but the effects are economically very small. Third, changes in competition to provide liquidity explain a considerable fraction of the variation in subsequent market liquidity. The effect is non-linear: the bid-ask spread is smallest around a natural level of competition, but increases as competition intensity deviates away from this point. 1Harvard University and Harvard Business School. I am most grateful to John Campbell, Shawn Cole and Erik Stafford for their constant support, guidance and insightful discussions. Jeremy Stein, Robin Greenwood and the seminar participants at the Harvard Finance Ph.D. Lunch also provided useful suggestions. I am deeply indebted to the National Commodities and Derivatives Exchange management and stuff for providing the data and answer-ing numerous questions regarding the trading platform and institutional context. Special thanks are due to my colleague Stefan Hunt for introducing me to the data and for many fruitful conversations. All errors are my own