How markets slowly digest changes in supply and demand

TL;DR

This paper reviews how markets gradually incorporate supply and demand changes into prices, emphasizing the slow, persistent nature of order flow and its implications for market efficiency and price dynamics.

Contribution

It provides a comprehensive review of recent theoretical and empirical work on price formation, highlighting the slow digestion of supply and demand and its effects on market microstructure.

Findings

Order flow exhibits long-memory and persistence.

Market impact and bid-ask spread depend on volume and time.

Prices are mainly influenced by supply and demand noise rather than external news.

Abstract

In this article we revisit the classic problem of tatonnement in price formation from a microstructure point of view, reviewing a recent body of theoretical and empirical work explaining how fluctuations in supply and demand are slowly incorporated into prices. Because revealed market liquidity is extremely low, large orders to buy or sell can only be traded incrementally, over periods of time as long as months. As a result order flow is a highly persistent long-memory process. Maintaining compatibility with market efficiency has profound consequences on price formation, on the dynamics of liquidity, and on the nature of impact. We review a body of theory that makes detailed quantitative predictions about the volume and time dependence of market impact, the bid-ask spread, order book dynamics, and volatility. Comparisons to data yield some encouraging successes. This framework suggests a novel interpretation of financial information, in which agents are at best only weakly informed and all have a similar and extremely noisy impact on prices. Most of the processed information appears to come from supply and demand itself, rather than from external news. The ideas reviewed here are relevant to market microstructure regulation, agent-based models, cost-optimal execution strategies, and understanding market ecologies.