Liquidity and Information in Order Driven Markets

Abstract:     
Does informed trading hurt liquidity? We address this question in a dynamic model of an order driven market with asymmetric information. In equilibrium, informed traders submit both market orders and limit orders, but market orders have a higher price impact than limit orders. Surprisingly, a higher share of informed traders (i) generates smaller bid-ask spreads, and (ii) has no effect on the price impact of orders. Competition among informed traders causes slippage - the fact that for an informed trader a limit order tends to execute at worse prices in the future. Slippage creates endogenous waiting costs for informed traders, and determines a novel component of the bid-ask spread. The model suggests several methods to estimate the probability of informed trading.

Number of Pages in PDF File: 60

Keywords: Bid-ask spread, price impact, information acquisition, volatility, trading volume, limit order book, waiting costs, slippage

JEL Classification: C7, D4, G1

working papers series