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Automated Liquidity Provision and the Demise of Traditional Market Making

  • Austin Gerig
  • David Michayluk

Traditional market makers are losing their importance as automated systems have largely assumed the role of liquidity provision in markets. We update the model of Glosten and Milgrom (1985) to analyze this new world: we add multiple securities and introduce an automated market maker who uses the relationships between securities to price order flow. This new automated participant transacts the majority of orders, sets prices that are more efficient, and increases informed and decreases uninformed traders' transaction costs. These results can explain the recent dominance of high frequency trading in US markets and the corresponding increase in trading volume and decrease in transaction costs for US stocks.

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File URL: http://arxiv.org/pdf/1007.2352
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Paper provided by arXiv.org in its series Papers with number 1007.2352.

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Date of creation: Jul 2010
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Handle: RePEc:arx:papers:1007.2352
Contact details of provider: Web page: http://arxiv.org/

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  1. Evan G. Gatev & William N. Goetzmann & K. Geert Rouwenhorst, 1999. "Pairs Trading: Performance of a Relative Value Arbitrage Rule," NBER Working Papers 7032, National Bureau of Economic Research, Inc.
  2. Caballe, Jordi & Krishnan, Murugappa, 1994. "Imperfect Competition in a Multi-security Market with Risk Neutrality," Econometrica, Econometric Society, vol. 62(3), pages 695-704, May.
  3. Dan Bernhardt & Bart Taub, 2008. "Cross-Asset Speculation in Stock Markets," Journal of Finance, American Finance Association, vol. 63(5), pages 2385-2427, October.
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