The Microstructure of Endogenous Liquidity Provision
64 Pages Posted: 15 Nov 2019 Last revised: 15 Oct 2020
Date Written: October 15, 2020
We analyze a nonlinear rational expectations equilibrium model with an ex post endogenous liquidity provision decision. Speed and information technology advantages allow endogenous liquidity providers (ELPs) to switch between limit and market orders after observing private information. This significantly influences the adverse selection faced by designated market makers (DMMs), thereby generating a gap between liquidity supply from DMMs and liquidity demand by informed traders. As a result, endogenous liquidity provision leads to two equilibrium regimes with nonlinear price impacts and the possibility of market breaks. These breaks occur when ELPs switch from liquidity provision to liquidity consumption as a consequence of unexpected shocks. Increasingly similar information among ELPs reduces the risk of systematic liquidity withdrawals but intensifies the DMMs’ adverse selection cost. Our model is relevant to various plausible settings and can help to explain a variety of financial market outcomes.
Keywords: Endogenous liquidity provision, fragile liquidity, market breaks, machine learning
JEL Classification: D82, D84, G10, G14
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