DP2889 Limit Order Book as a Market for Liquidity

Author(s): Thierry Foucault , Ohad Kadan , Eugene Kandel

Publication Date: August 2001

Keyword(s): limit order markets , market orders , liquidity

JEL(s): G10 , G14 , G24

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP2889.asp

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.