Informed Trading, Limit Order Book and Implementation Shortfall: Equilibrium and Asymptotics

Abstract

We propose a static equilibrium model for limit order book where $N\geq 1$ profit-maximizing investors receive an information signal regarding the liquidation value of the asset and execute via a competitive dealer with random initial inventory. While the dealer's initial position plays a role similar to noise traders in Kyle, he trades against a competitive limit order book populated by liquidity suppliers as in Glosten. We show that an equilibrium exists for bounded signal distributions, obtain closed form solutions for Bernoulli-type signals and propose a straightforward iterative algorithm to compute the equilibrium order book for the general case. We obtain the exact analytic asymptotics for the market impact of large trades and show that the functional form depends on the tail distribution of the private signal of the insiders. In particular, the impact follows a power law if the signal has fat tails while the law is logarithmic in case of lighter tails. Moreover, the tail distribution of the trade volume in equilibrium obeys a power law in our model. We find that the liquidity suppliers charge a minimum bid-ask spread that is independent of the amount of `noise' trading but increasing in the degree of informational advantage of insiders in equilibrium. The model also predicts that the order book flattens as the amount of noise trading increases converging to a model with proportional transactions costs. In case of a monopolistic insider we show that the last slice traded against the limit order book is priced at the liquidation value of the asset. However, competition among the insiders leads to aggressive trading causing the aggregate profit to vanish in the limiting case N → ∞. The numerical results also show that the spread increases with the number of insiders keeping the other parameters fixed. Finally, an equilibrium may not exist if the liquidation value is unbounded. We conjecture that existence of equilibrium requires a sufficient amount of competition among insiders if the signal distribution exhibit fat tails.