Liquidity Effects of Trading Frequency

TL;DR

This paper develops a discrete-time model of limit order books to analyze how trading frequency impacts market liquidity, revealing a dual effect where higher frequency can both improve efficiency and induce fragility leading to liquidity crises.

Contribution

It introduces a novel equilibrium-based framework connecting trading frequency to liquidity dynamics and endogenous crises, incorporating agents' market-neutrality conditions.

Findings

Higher trading frequency enhances market efficiency when agents provide liquidity.

Increased frequency can cause liquidity withdrawal if agents deviate from market-neutrality.

Endogenous liquidity crises, like flash crashes, can occur due to agents' belief deviations.

Abstract

In this article, we present a discrete time modeling framework, in which the shape and dynamics of a Limit Order Book (LOB) arise endogenously from an equilibrium between multiple market participants (agents). We use the proposed modeling framework to analyze the effects of trading frequency on market liquidity in a very general setting. In particular, we demonstrate the dual effect of high trading frequency. On the one hand, the higher frequency increases market efficiency, if the agents choose to provide liquidity in equilibrium. On the other hand, it also makes markets more fragile, in the sense that the agents choose to provide liquidity in equilibrium only if they are market-neutral (i.e., their beliefs satisfy certain martingale property). Even a very small deviation from market-neutrality may cause the agents to stop providing liquidity, if the trading frequency is sufficiently high, which represents an endogenous liquidity crisis (aka flash crash) in the market. This framework enables us to provide more insight into how such a liquidity crisis unfolds, connecting it to the so-called adverse selection effect.