Non-Stationary vs. Stationary Equilibrium in Dynamic Limit Order Markets

Abstract

We solve a non-stationary model of a limit order market to investigate time dynamics and the effects of adverse selection and path dependency on equilibrium strategies, market quality, welfare and the price impact of orders. We show the effects depend on volatility. When volatility is high, informed investors act as speculators, and increased adverse selection improves both market quality and welfare of uninformed investors who gradually become the best liquidity providers. When instead volatility is low, the informed act as market makers and crowd out the uninformed so that increased adverse selection deteriorates uninformed welfare despite improving market quality. Our non-stationary model delivers new results on depth, price impact, price informativeness/discovery and welfare compared to a standard stationary approach. Our results on spread, lead to new policy implications as they are driven by new transmission mechanisms.
We compare these findings with the results of a stationary version of our model.

Keywords: Limit order markets, asymmetric information, liquidity, market microstructure

JEL Classification: G10, G20, G24, D40