The Microstructure of Endogenous Liquidity Provision

62 Pages Posted: 15 Nov 2019

See all articles by F. Douglas Foster

F. Douglas Foster

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

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Junqing Kang

University of Technology Sydney (UTS), UTS Business School, Students

Shen Lin

PBCSF, Tsinghua University

Date Written: November 7, 2019

Abstract

We propose a nonlinear rational expectations equilibrium model of high-frequency endogenous liquidity provision to explore fragile liquidity. With fast trading speed and private information, high-frequency traders can either compete with designated market makers (DMMs) by providing liquidity or attempt to profit from speculative trades that consume liquidity. The risk from this endogenous liquidity provision, coupled with limits to participation by DMMs, intensifies the adverse selection faced by DMMs. This can generate a gap between liquidity supply from DMMs and liquidity demand by informed traders. As a result, endogenous liquidity provision produces fragile liquidity, with the possibility of market breaks when high-frequency traders switch from liquidity provision to liquidity consumption on the basis of unexpected information signals.

Keywords: endogenous liquidity provision, fragile liquidity, machine learning

JEL Classification: G10, G14

Suggested Citation

Foster, F. Douglas and He, Xue-Zhong 'Tony' and Kang, Junqing and Lin, Shen, The Microstructure of Endogenous Liquidity Provision (November 7, 2019). 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

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

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

HOME PAGE: http://www.firn.org.au

Junqing Kang (Contact Author)

University of Technology Sydney (UTS), UTS Business School, Students ( email )

Sydney
Australia
456198733 (Phone)

Shen Lin

PBCSF, Tsinghua University ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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