(In)Stability properties of limit order dynamics

We study the stability properties of the dynamics of the standard continuous limit-order mechanism that is used in modern equity markets. We ask whether such mechanisms are susceptible to "buttery effects" --- the iniction of large changes on common measures of market activity by only small perturbations of the order sequence. We show that the answer depends strongly on whether the market consists of "absolute" traders (who determine their prices independent of the current order book state) or "relative" traders (who determine their prices relative to the current bid and ask). We prove that while the absolute trader model enjoys provably strong stability properties, the relative trader model is vulnerable to great instability. Our theoretical results are supported by large-scale experiments using limit order data from INET, a large electronic exchange for NASDAQ stocks.