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Power laws in market microstructure

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  • Çetin, Umut
  • Waelbroeck, Henri

Abstract

We develop an equilibrium model for market impact of trades when investors with private signals execute via a trading desk. Fat tails in the signal distribution lead to a power law for price impact, while the impact is logarithmic for lighter tails. Moreover, the tail distribution of the equilibrium trade volume obeys a power law. The spread decreases with the degree of noise trading and increases with the number of insiders. In case of a monopolistic insider, the last slice traded against the limit order book is priced at the fundamental value of the asset reminiscent of [17]. However, competition among insiders leads to aggressive trading, hence vanishing prot in the limit. The model also predicts that the order book attens as the amount of noise trading increases converging to a model with proportional transactions costs with non-vanishing spread.

Suggested Citation

  • Çetin, Umut & Waelbroeck, Henri, 2023. "Power laws in market microstructure," LSE Research Online Documents on Economics 120809, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:120809
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    File URL: http://eprints.lse.ac.uk/120809/
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    References listed on IDEAS

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    12. Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2003. "A theory of power-law distributions in financial market fluctuations," Nature, Nature, vol. 423(6937), pages 267-270, May.
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    14. J. Doyne Farmer & Austin Gerig & Fabrizio Lillo & Henri Waelbroeck, 2013. "How efficiency shapes market impact," Quantitative Finance, Taylor & Francis Journals, vol. 13(11), pages 1743-1758, November.
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    1. Jonathan Ch'avez-Casillas & Jos'e E. Figueroa-L'opez & Chuyi Yu & Yi Zhang, 2024. "Adaptive Optimal Market Making Strategies with Inventory Liquidation Cos," Papers 2405.11444, arXiv.org.

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    More about this item

    Keywords

    limit order book; price impact; power laws; equilibrium; market microstructure; h-transform;
    All these keywords.

    JEL classification:

    • D50 - Microeconomics - - General Equilibrium and Disequilibrium - - - General
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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