Securities Trading when Liquidity Providers are Informed

Securities Trading when Liquidity Providers are Informed Abstract We study securities trading when liquidity is provided by informed agents—either because dealers have superior access to market information or because informed traders exploit strategies involving limit orders. In the case of informed dealers, we show that dealers and informed traders profit more at the expense of uninformed liquidity traders when markets are transparent than when markets are opaque. This is because transparency serves as a coordination device that reduces competition among informed traders. When the informed are allowed to choose whether to trade via market orders or price contingent (limit) orders, informed traders gravitate toward limit orders. The endogenous allocation of traders to order types maximizes competition among the informed thereby minimizing expected losses to liquidity traders. This extends Glosten's (1994) conclusion on the robustness of limit order markets to a setting where liquidity is provided by informed traders and competition among liquidity providers is imperfect in equilibrium. The predictions of our model are consistent with recent empirical evidence that the price impact of limit order arrivals is greater than that of market order executions. This suggests that the usual approach in empirical microstructure research of measuring adverse selection as the trade-correlated permanent component of price changes significantly understates the true importance of adverse selection in securities markets. Introduction Models of securities trading with asymmetric information typically examine settings in which informed traders submit market orders to liquidity providers who are uninformed and perfectly competitive. For example, the dealers in Glosten and Milgrom (1985), Kyle (1985) and Easley and O'Hara (1987) have no private information and set prices to break even in expectation. Similarly, in Glosten (1994) liquidity is provided by a book of limit orders submitted by perfectly competitive uninformed traders. A few models abandon the assumption of perfect competition. Glosten (1989) examines the price schedule posted by a single monopolist specialist in a setting where market orders are submitted by a trader with information and a liquidity need. Dennert (1993), Biais, Martimort and Rochet (2000) and Bondarenko (2001), consider settings where each of a collection of profit maximizing dealers posts a separate price schedule. A single informed trader and noise traders then choose how to allocate their market orders across dealers. Though dealers are imperfectly competitive in those models, they are still uninformed. This paper relaxes the assumption that liquidity providers are uninformed. We also relax the assumption that …