Working Paper: CEPR ID: DP2889
Authors: Thierry Foucault; Ohad Kadan; Eugene Kandel
Abstract: We develop a dynamic model of an order-driven market populated by discretionary liquidity traders. These traders must trade, yet can choose the type of order and are fully strategic in their decision. Traders differ in their impatience: less patient traders demand liquidity, more patient traders provide it. Three equilibrium patterns are obtained, and these patterns are determined by three parameters: the degree of impatience on the part of patient traders, which we model as the cost of execution delay in providing liquidity; their proportion in the population, which determines the degree of competition among the liquidity providers; and the tick size, which is the cost of the minimal price improvement. Despite its simplicity, the model generates a rich set of empirical predictions on the relation between market parameters, time to execution, and spreads.
Keywords: limit order markets; liquidity; market orders
JEL Codes: G10; G14; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| proportion of patient traders (I11) | market spreads (G10) |
| waiting costs (J32) | traders' impatience (D84) |
| traders' impatience (D84) | likelihood of placing market orders (C69) |
| tick size (Y10) | expected spreads (G19) |