Working Paper: CEPR ID: DP7551
Authors: Thierry Foucault; Ohad Kadan; Eugene Kandel
Abstract: We develop a dynamic model of a market with two specialized sides: traders posting quotes ("market makers") and traders hitting quotes ("market takers"). Traders monitor the market to seize profit opportunities, generating high frequency liquidity cycles. Monitoring decisions by market-makers and market-takers are self-reinforcing, generating multiple equilibria with differing liquidity levels and duration clustering. The trading rate is typically maximized when makers and takers are charged different fees or even paid rebates. The model yields several empirical implications regarding the determinants of make/take fees, the trading rate, the bid-ask spread, and the effects of algorithmic trading on liquidity and welfare.
Keywords: algorithmic trading; duration clustering; liquidity; maketake fees; monitoring; two-sided markets
JEL Codes: G12; G20; L14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monitoring decisions of market makers (G14) | monitoring decisions of market takers (D40) |
| monitoring decisions of market takers (D40) | monitoring decisions of market makers (G14) |
| monitoring decisions of market makers and market takers (G18) | liquidity in the market (G10) |
| decrease in monitoring costs for market takers (D40) | trading rate (F16) |
| algorithmic trading (C69) | monitoring costs for market takers (D41) |
| algorithmic trading (C69) | trading rate (F16) |
| maketake fees (D41) | trading rate (F16) |
| decrease in monitoring costs for market takers (D40) | liquidity consumption (E21) |
| liquidity consumption (E21) | market makers supply liquidity (G10) |
| algorithmic trading (C69) | welfare (I38) |
| maketake fees (fixed or endogenous) (D49) | individual expected profits (D22) |