The Microstructure of Endogenous Liquidity Provision

F. Douglas Foster, Xuezhong (Tony) He (), Junqing Kang and Shen Lin

No 402, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

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.

Keywords: endogenous liquidity provision; fragile liquidity; machine learning (search for similar items in EconPapers)
JEL-codes: G10 G14 (search for similar items in EconPapers)
Pages: 62 pages
Date: 2019-11-01
New Economics Papers: this item is included in nep-mon, nep-mst and nep-ore
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:uts:rpaper:402

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