Liquidity Provision and Market-Making in Different Uncertainty Regimes: Evidence from the COVID-19 Market Crash

Abstract

Kyle (1985) builds a pioneering and influential model, in which an insider observing private information submits an optimal order given the market-maker’s pricing rule, which is assumed a linear function of the aggregated order flow. We propose an extension to Kyle's model where different types of uncertainty regimes exist and where the market maker estimates market uncertainty and uses it to set her price. The model implies that the elasticity of prices to liquidity demand will increase in high uncertainty regimes. We test the outcome of the model empirically by studying the price formation process during the COVID-19 pandemic crash. A period of agitation with important announcements having a major impact on financial markets, such as the state lockdown and the Fed's fiscal response. We find that indeed the elasticity of prices to liquidity demand during the COVID-19 period has increased four times.

Keywords: Price Formation Process, Liquidity, COVID-19 Pandemic