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A Market-Clearing Role for Inefficiency on a Limit Order Book

Jeremy Large

No 2006-W08, Economics Papers from Economics Group, Nuffield College, University of Oxford

Abstract: Using a stochastic sequential game in ergodic equilibrium, this paper models limit order book trading dynamics. It deduces investor surplus and some agents' strategies from depth's stationarity, while bypassing altogether agents' intricate forecasting problems. Market inefficiency adjusts to induce equal supply and demand for liquidity over time. Consequently, at a given bid-ask spread surplus per investor is invariant to faster, more regular or more sophisticated trading, or modified queuing rules: apparent improvements are offset as inefficiency adjusts back to market-clearing levels. Moreover, investor surplus decreases with the spread. In the model, price discreteness fixes the spread at the tick size. Narrowing the tick is beneficial, but may be resisted by sell-side traders.

Keywords: stochastic sequential game; ergodic equilibrium; market microstructure; limit order book; market depths; bid-ask spread (search for similar items in EconPapers)
JEL-codes: C73 G14 G24 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2006-07-14
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-mst
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Journal Article: A market-clearing role for inefficiency on a limit order book (2009) Downloads
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