Large Orders in Small Markets: On Optimal Execution with Endogenous Liquidity Supply

Abstract

Increased intermediation made some investors "too large" for their markets. If such investor needs to sell quickly, then he cannot reach buyers who arrive later. Market makers then supply liquidity by taking on inventory to sell to future buyers. We endogenize both demand and supply of liquidity in a continuous-time Stackelberg game where the large seller moves first. Stealth trading by the seller turns out to be costly, privately and socially, because market makers experience additional cost not knowing when execution ends. If they do know then price pressure might subside before execution ends rationalizing such pattern observed in the data.

Keywords: large orders, market making, liquidity supply, liquidity demand

JEL Classification: G10