Limit Order Book as a Market for Liquidity

We develop a dynamic model of a limit order market populated by strategic liquidity traders of varying impatience. In equilibrium, patient traders tend to submit limit orders, whereas impatient traders submit market orders. Two variables are the key determinants of the limit order book dynamics in equilibrium: the proportion of patient traders and the order arrival rate. We offer several testable implications for various market quality measures such as spread, trading frequency, market resiliency, and time to execution for limit orders. Finally, we show the effect of imposing a minimal price variation on these measures. Copyright 2005, Oxford University Press.

[1]  Anat R. Admati,et al.  A Theory of Intraday Patterns: Volume and Price Variability , 1988 .

[2]  Kenneth A. Kavajecz,et al.  Eighths, Sixteenths and Market Depth: Changes in Tick Size and Liquidity Provision on the Nyse , 1999 .

[3]  Puneet Handa,et al.  Limit Order Trading , 1995 .

[4]  Burton Hollifield,et al.  Empirical Analysis of Limit Order Markets , 2001 .

[5]  Thierry Foucault,et al.  Order flow composition and trading costs in a dynamic limit order market 1 I am grateful to Bruno Bi , 1999 .

[6]  Christine A. Parlour,et al.  Equilibrium in a Dynamic Limit Order Market , 2003 .

[7]  H. Demsetz,et al.  The Cost of Transacting , 1968 .

[8]  Ohad Kadan.  Discrete Prices and Competition in a Dealer Market , 2002 .

[9]  Ananth N. Madhavan.  Market Microstructure: A Survey , 2000 .

[10]  Joel Hasbrouck,et al.  Trading Fast and Slow: Security Market Events in Real Time , 1999 .

[11]  Hans R. Stoll,et al.  The Components of the Bid-Ask Spread: A General Approach, Reviews of Financial Studies , 1997 .

[12]  L. Glosten.  Is the Electronic Open Limit Order Book Inevitable , 1994 .

[13]  Chester Spatt,et al.  An Empirical Analysis of the Limit Order Book and the Order Flow in the Paris Bourse , 1995 .

[14]  Lawrence Harris,et al.  Market vs. Limit Orders: The SuperDOT Evidence on Order Submission Strategy , 1996, Journal of Financial and Quantitative Analysis.

[15]  Patrik Sand̊as,et al.  Adverse Selection and Competitive Market Making: Empirical Evidence from a Limit Order Market , 2001 .

[16]  Limit Orders and the Bid-Ask Spread , 2003 .

[17]  Christine A. Parlour,et al.  Liquidity-Based Competition for Order Flow , 2003 .

[18]  Jeffrey R. Russell,et al.  Autoregressive Conditional Duration: A New Model for Irregularly Spaced Transaction Data , 1998 .

[19]  Christine A. Parlour.  Price Dynamics in Limit Order Markets , 1998 .

[20]  Paul J. Irvine,et al.  Liquidity Beyond the Inside Spread: Measuring and Using Information in the Limit Order Book , 2000 .

[21]  Ian Domowitz.  A Taxonomy of Automated Trade Execution Systems , 1992 .

[22]  Ian Domowitz,et al.  Auctions as algorithms : Computerized trade execution and price discovery , 1994 .

[23]  Lawrence Harris,et al.  Liquidity , Trading Rules and Electronic Trading Systems , 1990 .

[24]  Andrew J. Patton,et al.  Impacts of Trades in an Error-Correction Model of Quote Prices , 2000 .

[25]  P. Jain,et al.  Institutional Design and Liquidity at Stock Exchanges Around the World , 2003 .

[26]  A. Lo,et al.  Econometric Models of Limit-Order Executions , 1997 .

[27]  A. Shleifer,et al.  The Limits of Arbitrage , 1995 .

[28]  Maureen O'Hara,et al.  Can transparent markets survive , 2000 .

[29]  Kenneth A. Kavajecz.  A Specialist's Quoted Depth and the Limit Order Book , 1999 .

[30]  Maureen O'Hara,et al.  Time and the Process of Security Price Adjustment , 1992 .

[31]  S. Viswanathan,et al.  Variations in Trading Volume, Return Volatility, and Trading Costs: Evidence on Recent Price Formation Models , 1993 .

[32]  Robert J. Bloomfield,et al.  The 'Make or Take' Decision in an Electronic Market: Evidence on the Evolution of Liquidity , 2002 .

[33]  Sugato Chakravarty,et al.  An Integrated Model of Market and Limit Orders , 1995 .

[34]  Donald B. Keim,et al.  Empirical evidence on the behavior of institutional traders , 1995 .

[35]  Thomas J. George,et al.  Estimation of the Bid-Ask Spread and Its Components: A New Approach , 1991 .

[36]  Liquidity Supply and Demand in Limit Order Markets , 2002 .

[37]  Joel Hasbrouck,et al.  Securities Trading in the Absence of Dealers: Trades and Quotes on the Tokyo Stock Exchange , 1995 .

[38]  L. Harris.  Minimum Price Variations, Discrete Bid-Ask Spreads, and Quotation Sizes , 1994 .

[39]  William Feller,et al.  An Introduction to Probability Theory and Its Applications , 1951 .

[40]  A. Kyle.  Continuous Auctions and Insider Trading , 1985 .

[41]  Ananth N. Madhavan,et al.  Why Do Security Prices Change? A Transaction-Level Analysis of Nyse Stocks , 1996 .

[42]  Duane J. Seppi.  Liquidity Provision with Limit Orders and a Strategic Specialist , 1997 .

[43]  Kenneth A. Kavajecz,et al.  Technical Analysis and Liquidity Provision , 2004 .

[44]  Michael S. Pagano,et al.  A Closing Call's Impact on Market Quality at Euronext Paris , 2003 .

[45]  Brian F. Smith,et al.  The costs and determinants of order aggressiveness , 2000 .

[46]  Paul R. Milgrom,et al.  Bid, ask and transaction prices in a specialist market with heterogeneously informed traders , 1985 .

[47]  Lawrence Harris,et al.  Optimal Dynamic Order Submission Strategies In Some Stylized Trading Problems , 1998 .

[48]  J. Rochet,et al.  COMPETING MECHANISMS IN A COMMON VALUE ENVIRONMENT , 2000 .