Limit Order Markets under Asymmetric Information

Abstract

We develop a model of dynamic limit order markets under asymmetric information that can be simplified sufficiently to be solved analytically. We use the trader arrival and information environment of the traditional sequential trade models but swap the dealer-based trading core of these models for a dynamic limit order market. We find that informed traders tend to “make” liquidity in illiquid markets and “take” liquidity from more liquid markets. The arrival of marketable and limit orders as well as the passage of time may convey information, resulting in repricing of orders in the book and generating the frequent cancellations and resubmissions that have become a staple of modern markets.

Keywords: limit order book, asymmetric information, sequential trade models, limit order markets, limit orders, market orders, informed traders, cancellations, time-to-execution

JEL Classification: G10, G14, D82