The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
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The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
The “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityraft: March 2002This Version: August 2002♦Robert Bloomfield (rjb9fậ■comell.edu) and Maureen O’Hara (molWcornell.edu) are from the Johnson Graduate School of Management, Cornell University. Gideon Saar (gsaarfflstem.nyu.edu) is from the Stern School, New York University, and is currently a Visiting R The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityesearch Economist at The New York Stock Exchange. Financial support for this project was obtained from New York University's Salomon Center for the StThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
udy of Financial Institutions.1The “Make or Take” Decision ill an Electronic Market: Evidence on the Evolution of LiquidityAbstractThis paper uses expThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity electronic markets, as well as informed traders and liquidity traders. We focus on the strategies of the traders, and how these are affected by trader type, characteristics of the market, and characteristics of the asset. We find that informed traders use more limit orders than do liquidity traders The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity. We also find that liquidity provision shifts over time, with informed traders increasingly providing liquidity in markets. This evolution is consistThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
ent with the risk advantage informed traders have in placing limit orders. Thus, a market making role emerges endogenously in our electronic markets.2The “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityrading ol a wide variety of financial assets. Stock exchanges in many countries including Canada. Germany, Israel, and the United Kingdom have adopted electronic struc tures to trade equities, as has Euronext, the new market combining eight former European stock exchanges. In the United States. Elec The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityuonic Communications Networks (F.CNs) such as island, ĩnslinel, and Archipelago use an electronic order book structure to trade as much as 45% of theThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
volume on Nasdaq. There are now several electronic systems trading corporate bonds (e.g.. eSpeed) and government bonds (Govpix), while, in foreign excThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquiditylargest futures market, and with the opening of the new International Securities Exchange, even options now trade in electronic markets.Many such electronic markets are organized as electronic limit order books. In this structure, there is no designated liquidity provider such as a specialist or a d The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityealer; instead, liquidity arises endogenously from the submitted orders of traders. Traders who submit orders to buy or sell the asset al a particularThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
price are said to "make" liquidity, while traders who choose to hit existing orders arc said to “take” liquidity', lhe spread and price behavior in sThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquiditye the evolution of liquidity in an electronic limit order market. Our market setting possesses the salient leatures of electronic markets: continuous trading, a visible “book” of orders, price-time order priority lilies, instantaneous trade reporting rules, order cancellation capabilities, and both The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquiditylimit order and3https://khothuvien.cori!market order functionality. While many experiments have used continuous double-auction market similar to the eThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
lectronic markets we investigate (see the review by Sunder [1995]), our experiment is the first to focus primarily on the provision and use of liquidiThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityl liquidity needs. We manipulate both the prior distribution and the realizations of security values. These manipulations allow US to analyze market behavior in ways unavailable in actual markets. In particular, we can analyze explicitly the strategies of informed and liquidity traders, and we can d The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityetermine the factors that influence traders’ make or take decisions.Our particular focus in this paper is on three questions. First, how do informed aThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
nd liquidity traders differ in their provision and use of market liquidity? Second, how do characteristics of the market, such as depth in the book orThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityvision of market liquidity? Addressing these questions allows US to provide insights not only into the functioning of electronic markets, but into the emergence of market liquidity as well.Numerous authors in finance have examined aspects of these questions both theoretically and empirically, and th The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityere has also been related work in the experimental literature. Theoretical analyses of limit orders include Cohen, Maier, Schwartz, and Whitcomb [1981The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
]; Rock [1990]; Angel [1994]; Glosten [1994]; Kumar and Seppi [1994]; Chakravarty and Holden [1995]; Parlour [1998]; Harris [1998]; Foucault [1999]; PThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity1995]; Hollifield, Miller, and Sandas [1999]; Ahn. Bae and Chan [2001]; and Hasbrouck4https://khothuvien.cori!and Saar [2001]. In general, these analyses have provided useful characterizations of limit order behavior, but the complexity of traders’ decision problems has required selectivity in what The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityaspects of trader or market behavior can be considered.Our analysis provides a number of important new results. Of special significance, we find thatThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
informed traders actively submit limit orders. Indeed, both trader types use limit orders and market orders, but informed traders tend to use more limThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityliquidity, and do not provide it. One consequence of this behavior is that the book of orders has information content.What we find particularly intriguing is that liquidity provision changes dramatically over time, and the key to this evolution is the behavior of the informed traders. When trading b The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityegins, informed traders are much more likely to take liquidity, hitting existing orders so as to profit from their private information. As prices moveThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
toward true values, the informed traders shift to submitting limit orders. This shift is so pronounced that towards the end of the trading period infThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityde liquidity in various market conditions even as they speculate on their information. Liquidity trader's who need to buy or sell a large number of shares, on the other hand, tend to use more limit orders early on, but as the end of the trading period approaches switch to market orders in order to m The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityeet their targets.The informed traders also seem to change their strategies depending on the value of their information. When that value is high, infoThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
rmed traders tend to use more market orders in order to realize trading profit before prices adjust. When the value of their information is low, they The “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity for the informed, acting as both traders and dealers, highlights the important ways that information influences markets. While it is the trading of the informed that ultimately moves prices to efficient levels, the superior information of the informed also makes these traders better able to provide The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity liquidity to other traders in the market. Thus, unlike in theoretical models where the informed stop trading once their information is incorporated iThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
nto prices, we find that the informed now profit further by taking on the role of liquidity providers and essentially earning the spread. In a symmetrThe “Make or Take” Decision in an Electronic Market: Evidence on the Evolution of LiquidityRobert Bloomfield, Maureen O'Hara, and Gideon Saar*First Dr The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidityear risk. We show that in an asymmetric information setting, it is the infonned traders who ultimately have the risk advantage because they- know more about where the price should be. Thus, a market-making role arises endogenously in our electronic markets, adopted by traders for whom the risk of en The “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquiditytering a limit order is lower than it is for other traders.Our analysis may suggest why it is that electronic markets have been so successful in compeThe “Make or Take” Decision in an Electronic Market Evidence on the Evolution of Liquidity
ting with more traditional market structures. Even in the presence of information asymmetry, the traders themselves will provide liquidity, eschewingGọi ngay
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