The effect of algorithmic trading on agricultural commodities market quality

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Arzandeh, Neda
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The growing use of algorithms has significantly changed trading. These changes have been subjected to an ongoing debate in the finance literature. Some studies have found that algorithmic trading (AT) has a positive effect on market quality by increasing the competition, trading volume and liquidity, and lowering trading costs. Algorithmic traders provide liquidity when it is expensive and take it when it is cheap. On the other hand, others argue that AT may increase volatility and adverse selection. The difference in speed between fast and slow traders not only causes adverse selection, but it leads to wider spreads. We study the effect of AT on market quality, trade size and volatility, focusing on five agricultural commodity futures markets listed in the CME Group during the period of December 2015 to March 2016. The commodities include wheat, soybean, corn, lean hogs and live cattle. We control for USDA announcements released during the period of study, the day of the week, and intraday movements of AT. We find that AT improves market quality by narrowing the effective half spread (an estimate of the liquidity cost) in all markets. The effect is stronger in lean hogs and live cattle markets where AT also decreases the adverse selection (the reflection of the existence of different levels of information in the market). Algorithmic traders are more active when transaction costs and information asymmetry are lower. AT also decreases volatility in all markets. Our results show that the USDA announcements are significant only in the soybean market. We also find that the effect of the day of the week on AT is only significant in the corn market. The effect of the opening time of the market on AT is positive in soybean and corn, and negative in live cattle. The closing time is negative in all markets except live cattle where it is not significant. Finally, we perform an impulse response analysis. We find that the initial reaction of QHS and RS to a shock of AT is positive, the reaction of EHS and PI is negative, and the effect is always temporary.
Algorithmic trading, Market quality