Limit order books and trade informativeness

Abstract

In the microstructure literature, information asymmetry is an important determinant of market liquidity. The classic setting is that uninformed dedicated liquidity suppliers charge price concessions when incoming market orders are likely to be informationally motivated. In limit order book (LOB) markets, however, this relationship is less clear, as market participants can switch roles, and freely choose to immediately demand or patiently supply liquidity by submitting either market or limit orders. We study the importance of information asymmetry in LOBs based on a recent sample of 30 German Deutscher Aktienindex (DAX) stocks. We find that Hasbrouck's (1991) measure of trade informativeness Granger causes book liquidity, in particular that required to fill large market orders. Picking-off risk due to public news-induced volatility is more important for top-of-the book liquidity supply. In our multivariate analysis, we control for volatility, trading volume, trading intensity and order imbalance to isolate the effect of trade informativeness on book liquidity.

Keywords:

• liquidity
• limit order book
• trade informativeness
• volatility

Acknowledgements

We thank Ekkehart Boehmer, Ruslan Goyenko, Thierry Foucault, and participants of the 2005 European Finance Association Meeting, the 2005 German Finance Association Meeting (where we received the outstanding paper award) and seminars at the University of Copenhagen, University of London, University Louvain-la-Neuve, University Carlos III de Madrid, and the University of Zurich for useful comments. An anonymous referee greatly helped to improve the exposition of the paper. We thank Stefan Frey for his invaluable work on the LOB data, Kerstin Kehrle for research assistance, and the Deutsche Börse Group for data sponsorship, in particular Uwe Schweickert and Miroslav Budomir who shared their knowledge of the XETRA LOB system with us. We further thank the Belgian Fonds National de la Recherche Scientifique, the Center for Financial Research, Cologne, the German Research Foundation, as well as the Netherlands Organization for Scientific Research for financial support. The opinions expressed in this article are those of the authors and do not necessarily reflect the views of Fifth Third Asset Management, Inc. We are responsible for any remaining errors.

Notes

We define ‘price concession’ as the hypothetical transaction price for a given trade volume relative to a reference price (e.g. the midquote or the best quote). For limit order markets, we prefer price concession to the bid-ask half spread as a measure of liquidity, since depth at the best quote is often too small to transact the market order, which then runs up the book.

Traders seem to transact in terms of value, not in terms of number of shares. That is, we find that the average value per trades is similar across stocks, which is not true for the average number of shares per trade. The reason is that, in the cross-section, stocks trade at different price levels.