Order-flow-based Leading Indicators of Short-term Liquidity Shortfalls

Which components of the overall message traffic are effective leading indicators of impending liquidity shortfalls? Using detailed message-level data that flags the orders of HFTs (high-frequency traders), agency ATs (algorithmic traders), and non-ATs, we show that, after controlling for volume and volatility, only the HFTs’ net buying pressure, computed from the inflow of both aggressive and non-aggressive orders, precedes increases in both immediacy costs and price impacts in the short run. Consistent with market making theories of active risk management, cancellations and revisions of outstanding limit orders relate to preceding efficient price returns and enhance the overall signaling capacity of the HFTs’ order flow. Market-wide indicators of the HFTs’ net buying pressure add extra power in anticipating single-stock liquidity drops.