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Automated Liquidity Provision

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 prices order flow for all securities contemporaneously. This automated participant transacts the majority of orders, sets prices that are more efficient, reduces spreads, and increases informed and decreases uninformed traders' transaction costs. The model's predictions match very well with recent empirical findings and are difficult to replicate with alternative models.

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File URL: https://www.uts.edu.au/sites/default/files/rp345.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 345.

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Length: 34 pages
Date of creation: 01 Jan 2014
Publication status: Published as: Gerig, A. and Michayluk, D., 2017, "Automated Liquidity Provision", Pacific-Basin Finance Journal, 45, 1-13.
Handle: RePEc:uts:rpaper:345
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  12. Austin Gerig, 2012. "High-Frequency Trading Synchronizes Prices in Financial Markets," Papers 1211.1919, arXiv.org.
  13. Fricke, Daniel & Gerig, Austin, 2014. "Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets," Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100402, Verein für Socialpolitik / German Economic Association.
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  18. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
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  22. Alex Boulatov & Terrence Hendershott & Dmitry Livdan, 2013. "Informed Trading and Portfolio Returns," Review of Economic Studies, Oxford University Press, vol. 80(1), pages 35-72.
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  25. Hendershott, Terrence & Moulton, Pamela C., 2011. "Automation, speed, and stock market quality: The NYSE's Hybrid," Journal of Financial Markets, Elsevier, vol. 14(4), pages 568-604, November.
  26. Chordia, Tarun & Sarkar, Asani & Subrahmanyam, Avanidhar, 2011. "Liquidity Dynamics and Cross-Autocorrelations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(03), pages 709-736, June.
  27. Robert Litzenberger & Jeff Castura & Richard Gorelick, 2012. "The Impacts of Automation and High Frequency Trading on Market Quality," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 59-98, October.
  28. Harold Demsetz, 1968. "The Cost of Transacting," The Quarterly Journal of Economics, Oxford University Press, vol. 82(1), pages 33-53.
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