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

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  • Jeremy Large
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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.nuff.ox.ac.uk/economics/papers/2006/w8/TickWelfareJuly06.pdf
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    Bibliographic Info

    Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 2006-W08.

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    Date of creation: 01 Jul 2006
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    Handle: RePEc:oxf:wpaper:2006-w08

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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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    1. Cordella, Tito & Foucault, Thierry, 1999. "Minimum Price Variations, Time Priority, and Quote Dynamics," Journal of Financial Intermediation, Elsevier, vol. 8(3), pages 141-173, July.
    2. 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.
    3. 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.
    4. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2003. "Limit Order Book as a Market for Liquidity," Discussion Paper Series dp321, The Center for the Study of Rationality, Hebrew University, Jerusalem.
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