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A Market-Clearing Role for Inefficiency on a Limit Order Book

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Author Info
Jeremy Large () (All Souls College, University of Oxford)

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Abstract

Using a stochastic sequential game in ergodic equilibrium, this paper models limit order book trading dynamics. It deduces investor surplus and some agents' strategies from depth's stationarity, while bypassing altogether agents' intricate forecasting problems. Market inefficiency adjusts to induce equal supply and demand for liquidity over time. Consequently, at a given bid-ask spread surplus per investor is invariant to faster, more regular or more sophisticated trading, or modified queuing rules: apparent improvements are offset as inefficiency adjusts back to market-clearing levels. Moreover, investor surplus decreases with the spread. In the model, price discreteness fixes the spread at the tick size. Narrowing the tick is beneficial, but may be resisted by sell-side traders.

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File URL: http://www.nuffield.ox.ac.uk/economics/papers/2006/w8/TickWelfareJuly06.pdf
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Publisher Info
Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2006-W08.

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Length: 40 pages
Date of creation: 14 Jul 2006
Date of revision:
Handle: RePEc:nuf:econwp:0608

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Web page: http://www.nuff.ox.ac.uk/economics/

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Related research
Keywords: stochastic sequential game ergodic equilibrium market microstructure limit order book market depths bid-ask spread

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Find related papers by JEL classification:
C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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  1. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
    • Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November. [Downloadable!] (restricted)
  2. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society. [Downloadable!]
    Other versions:
  3. Parlour, Christine A, 1998. "Price Dynamics in Limit Order Markets," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 11(4), pages 789-816.
  4. Foucault, Thierry, 1999. "Order flow composition and trading costs in a dynamic limit order market1," Journal of Financial Markets, Elsevier, vol. 2(2), pages 99-134, May. [Downloadable!] (restricted)
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  8. Chakravarty Sugato & Holden Craig W., 1995. "An Integrated Model of Market and Limit Orders," Journal of Financial Intermediation, Elsevier, vol. 4(3), pages 213-241, July. [Downloadable!] (restricted)
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  9. Jones, Charles M. & Lipson, Marc L., 2001. "Sixteenths: direct evidence on institutional execution costs," Journal of Financial Economics, Elsevier, vol. 59(2), pages 253-278, February. [Downloadable!] (restricted)
  10. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November. [Downloadable!] (restricted)
  11. Ronald L. Goettler & Christine A. Parlour & Uday Rajan, 2005. "Equilibrium in a Dynamic Limit Order Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2149-2192, October. [Downloadable!] (restricted)
  12. Domowitz, Ian & Wang, Jianxin, 1994. "Auctions as algorithms : Computerized trade execution and price discovery," Journal of Economic Dynamics and Control, Elsevier, vol. 18(1), pages 29-60, January. [Downloadable!] (restricted)
  13. Handa, Puneet & Schwartz, Robert A, 1996. " Limit Order Trading," Journal of Finance, American Finance Association, vol. 51(5), pages 1835-61, December. [Downloadable!] (restricted)
  14. Seppi, Duane J, 1997. "Liquidity Provision with Limit Orders and a Strategic Specialist," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(1), pages 103-50.
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  16. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2005. "Limit Order Book as a Market for Liquidity," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 18(4), pages 1171-1217. [Downloadable!] (restricted)
    Other versions:
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