Automated liquidity provision

Publication Type:
Journal Article
Citation:
Pacific Basin Finance Journal, 2017, 45 pp. 1 - 13
Issue Date:
2017-10-01
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© 2016 Over the last decade, the task of liquidity provision in many markets has shifted from traditional market makers to autonomous, computerized trading systems. These automated systems collect, process, and react to market-wide information quicker and more comprehensively than the humans they have replaced. Here, we update the model of Glosten and Milgrom (1985) to analyze how the automation of liquidity provision affects market quality, the transaction costs of market participants, and volatility. To Glosten and Milgrom's original model, we add multiple securities and introduce an automated market maker who prices order flow for all securities contemporaneously. We find that the automated market maker transacts the majority of orders, sets prices that are more efficient, increases informed and decreases uninformed traders' transaction costs, and has no effect on volatility. The model's predictions match very well with recent empirical findings and are difficult to replicate with alternative models.
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