Random walks, liquidity molasses and critical response in financial markets

TL;DR

This paper investigates how long-range liquidity fluctuations and order flow correlations influence stock price dynamics, revealing a 'liquidity molasses' effect that stabilizes markets despite persistent trade sign memory.

Contribution

It provides empirical evidence that long-range liquidity fluctuations and bid-ask anti-correlations create a 'liquidity molasses,' explaining diffusive prices despite persistent trade sign correlations.

Findings

Power-law decay of impact function due to liquidity effects

Confirmation of long-range liquidity fluctuations in empirical data

Identification of bid-ask anti-correlation as a stabilizing factor

Abstract

Stock prices are observed to be random walks in time despite a strong, long term memory in the signs of trades (buys or sells). Lillo and Farmer have recently suggested that these correlations are compensated by opposite long ranged fluctuations in liquidity, with an otherwise permanent market impact, challenging the scenario proposed in Quantitative Finance 4, 176 (2004), where the impact is *transient*, with a power-law decay in time. The exponent of this decay is precisely tuned to a critical value, ensuring simultaneously that prices are diffusive on long time scales and that the response function is nearly constant. We provide new analysis of empirical data that confirm and make more precise our previous claims. We show that the power-law decay of the bare impact function comes both from an excess flow of limit order opposite to the market order flow, and to a systematic anti-correlation of the bid-ask motion between trades, two effects that create a `liquidity molasses' which dampens market volatility.