How does latent liquidity get revealed in the limit order book?

TL;DR

This paper introduces a mechanism to infer latent, unobservable liquidity from real market data, explores its implications for market stability, and analyzes how latent liquidity affects price impact and potential liquidity crises.

Contribution

It proposes a simple, consistent model linking latent and observable order books, enabling quantitative estimation and analysis of market stability and impact.

Findings

Successful estimation of latent order book from real data across 100+ assets

Identification of a market instability threshold related to latent order revelation

Analysis of price impact regimes and liquidity crisis conditions

Abstract

Latent order book models have allowed for significant progress in our understanding of price formation in financial markets. In particular they are able to reproduce a number of stylized facts, such as the square-root impact law. An important question that is raised -- if one is to bring such models closer to real market data -- is that of the connection between the latent (unobservable) order book and the real (observable) order book. Here we suggest a simple, consistent mechanism for the revelation of latent liquidity that allows for quantitative estimation of the latent order book from real market data. We successfully confront our results to real order book data for over a hundred assets and discuss market stability. One of our key theoretical results is the existence of a market instability threshold, where the conversion of latent order becomes too slow, inducing liquidity crises. Finally we compute the price impact of a metaorder in different parameter regimes.