Automated Liquidity Provision Across Related Securities

Summary

This document updates the Glosten–Milgrom model of informed and uninformed trading to examine how automated liquidity providers affect markets. The revised framework includes multiple securities and an automated market maker that uses relationships among them to set prices for incoming orders. The central idea is that cross-security information can help automated systems quote more efficiently than traditional market makers operating without that approach.

The model indicates that the automated participant handles most orders and sets more efficient prices. It also predicts lower transaction costs for informed traders and higher costs for uninformed traders. These results are offered as a possible explanation for high-frequency trading’s prominence in US markets, alongside increased trading volume and lower stock transaction costs. The document summarizes model findings but provides no empirical details, assumptions, or tests with which to assess their scope. Its conclusions should therefore be read as implications of the proposed model, rather than evidence that automated liquidity provision has displaced traditional market makers in every setting.

Key ideas

• The model extends Glosten–Milgrom to include multiple related securities.
• An automated market maker uses cross-security relationships to price order flow.
• The model predicts that the automated participant handles most orders and sets more efficient prices.
• Informed traders’ transaction costs fall while uninformed traders’ costs rise in the model.
• The findings are proposed as an explanation for high-frequency trading’s prominence and changing US stock market costs.

Tags

# Automated Liquidity Provision and the Demise of Traditional Market Making


# Automated Liquidity Provision and the Demise of Traditional Market Making









Traditional market makers are losing their importance as automated systems have largely assumed the role of liquidity provision in markets. We update the model of Glosten and Milgrom (1985) to analyze this new world: we add multiple securities and introduce an automated market maker who uses the relationships between securities to price order flow. This new automated participant transacts the majority of orders, sets prices that are more efficient, and increases informed and decreases uninformed traders' transaction costs. These results can explain the recent dominance of high frequency trading in US markets and the corresponding increase in trading volume and decrease in transaction costs for US stocks.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.