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, liquidity, market orders
JEL(s): G10, G14, G24
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2889

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.