The Microstructure of Endogenous Liquidity Provision

64 Pages Posted: 15 Nov 2019 Last revised: 15 Oct 2020

See all articles by F. Douglas Foster

F. Douglas Foster

The University of Sydney - Discipline of Finance; Financial Research Network (FIRN)

Xuezhong He

Xi'an Jiaotong-Liverpool University (XJTLU)

Junqing Kang

Sun Yat-sen University (SYSU) - Lingnan (University) College

Shen Lin

Tianjin University - College of Management and Economics; PBCSF, Tsinghua University

Date Written: October 15, 2020

Abstract

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

Suggested Citation

Foster, F. Douglas and He, Xue-Zhong 'Tony' and Kang, Junqing and Lin, Shen, The Microstructure of Endogenous Liquidity Provision (October 15, 2020). Available at SSRN: https://ssrn.com/abstract=3482259 or http://dx.doi.org/10.2139/ssrn.3482259

F. Douglas Foster

The University of Sydney - Discipline of Finance ( email )

P.O. Box H58
Sydney, NSW 2006
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Xue-Zhong 'Tony' He

Xi'an Jiaotong-Liverpool University (XJTLU) ( email )

111 Renai Road, SIP
Suzhou, JiangSu province 215123
China

Junqing Kang (Contact Author)

Sun Yat-sen University (SYSU) - Lingnan (University) College ( email )

135 Xingang Xi Road
Guangzhou, Guangzhou 510275
China

Shen Lin

Tianjin University - College of Management and Economics ( email )

NO.92 Weijin Road
Nankai District
Tianjin, 300072
China

PBCSF, Tsinghua University ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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