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The Microstructure of Endogenous Liquidity Provision

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Abstract

We propose a nonlinear rational expectations equilibrium model of high-frequency endogenous liquidity provision to explore fragile liquidity. With fast trading speed and private information, high-frequency traders can either compete with designated market makers (DMMs) by providing liquidity or attempt to profit from speculative trades that consume liquidity. The risk from this endogenous liquidity provision, coupled with limits to participation by DMMs, intensifies the adverse selection faced by DMMs. This can generate a gap between liquidity supply from DMMs and liquidity demand by informed traders. As a result, endogenous liquidity provision produces fragile liquidity, with the possibility of market breaks when high-frequency traders switch from liquidity provision to liquidity consumption on the basis of unexpected information signals.

Suggested Citation

  • F. Douglas Foster & Xue-Zhong He & Junqing Kang & Shen Lin, 2019. "The Microstructure of Endogenous Liquidity Provision," Research Paper Series 402, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:402
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    Cited by:

    1. Zhicheng Li & Haipeng Xing & Xinyun Chen, 2019. "A multifactor regime-switching model for inter-trade durations in the limit order market," Papers 1912.00764, arXiv.org.
    2. Arifovic, Jasmina & He, Xue-zhong & Wei, Lijian, 2022. "Machine learning and speed in high-frequency trading," Journal of Economic Dynamics and Control, Elsevier, vol. 139(C).

    More about this item

    Keywords

    endogenous liquidity provision; fragile liquidity; machine learning;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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