How Markets Slowly Digest Changes in Supply and Demand

111 Pages Posted: 15 Sep 2008

See all articles by Jean-Philippe Bouchaud

Jean-Philippe Bouchaud

Capital Fund Management

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Fabrizio Lillo

Università di Bologna

Date Written: September 11, 2008


In this article we revisit the classic problem of tatonnement in price formation from a microstructure point of view, reviewing a recent body of theoretical and empirical work explaining how fluctuations in supply and demand are slowly incorporated into prices. Because revealed market liquidity is extremely low, large orders to buy or sell can only be traded incrementally, over periods of time as long as months. As a result order flow is a highly persistent long-memory process. Maintaining compatibility with market efficiency has profound consequences on price formation, on the dynamics of liquidity, and on the nature of impact. We review a body of theory that makes detailed quantitative predictions about the volume and time dependence of market impact, the bid-ask spread, order book dynamics, and volatility. Comparisons to data yield some encouraging successes. This framework suggests a novel interpretation of financial information, in which agents are at best only weakly informed and all have a similar and extremely noisy impact on prices. Most of the processed information appears to come from supply and demand itself, rather than from external news. The ideas reviewed here are relevant to market microstructure regulation, agent-based models, cost-optimal execution strategies, and understanding market ecologies.

Keywords: Financial markets, Market microstructure, Market impact, Order flow

JEL Classification: G10

Suggested Citation

Bouchaud, Jean-Philippe and Farmer, J. Doyne and Lillo, Fabrizio, How Markets Slowly Digest Changes in Supply and Demand (September 11, 2008). Available at SSRN: or

Jean-Philippe Bouchaud

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
+33 1 49 49 59 20 (Phone)

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom


Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)


Fabrizio Lillo (Contact Author)

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126

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