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

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  • Jeremy Large

    (All Souls College, University of Oxford)

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.

Suggested Citation

  • Jeremy Large, 2006. "A Market-Clearing Role for Inefficiency on a Limit Order Book," Economics Papers 2006-W08, Economics Group, Nuffield College, University of Oxford.
    • Handle: RePEc:nuf:econwp:0608
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    References listed on IDEAS

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    Cited by:

    1. Degryse, Hans & Van Achter, Mark & Wuyts, Gunther, 2009. "Dynamic order submission strategies with competition between a dealer market and a crossing network," Journal of Financial Economics, Elsevier, vol. 91(3), pages 319-338, March.
    2. Alexander Bechtel & Angelo Ranaldo & Jan Wrampelmeyer, 2023. "Liquidity Risk and Funding Cost," Review of Finance, European Finance Association, vol. 27(2), pages 399-422.
    3. Jeremy Large & Thomas Norman, 2008. "Ergodic Equilibria in Stochastic Sequential Games," Economics Series Working Papers 405, University of Oxford, Department of Economics.
    4. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2013. "Liquidity Cycles and Make/Take Fees in Electronic Markets," Journal of Finance, American Finance Association, vol. 68(1), pages 299-341, February.
    5. Daniel Havran & Kata Varadi, 2015. "Price Impact and the Recovery of the Limit Order Book: Why Should We Care About Informed Liquidity Providers?," CERS-IE WORKING PAPERS 1540, Institute of Economics, Centre for Economic and Regional Studies.
    6. Alexander Bechtel & Angelo Ranaldo & Jan Wrampelmeyer, 2023. "Liquidity Risk and Funding Cost," Review of Finance, European Finance Association, vol. 27(2), pages 399-422.
    7. Field, Jonathan & Large, Jeremy, 2008. "Pro-rata matching and one-tick futures markets," CFS Working Paper Series 2008/40, Center for Financial Studies (CFS).
    8. Bruce Lehmann, 2008. "Arbitrage-free Limit Order Books and the Pricing of Order Flow Risk," NBER Working Papers 13848, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    stochastic sequential game; ergodic equilibrium; market microstructure; limit order book; market depths; bid-ask spread;
    All these keywords.

    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; Insider Trading
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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