Abstract
How does a market digest order imbalance? We show that when market participants learn about the level of adverse selection (the risk of trading against better-informed counterparties) from order flow, a large order imbalance can be destabilizing, causing sharp price movements and evaporation of liquidity, as it signals high toxicity. While such effect is consistent with the practitioner view that order flow is informative about toxicity, it contrasts with standard microstructure models in which the level of adverse selection is assumed to be known and thus order imbalance improves liquidity by revealing private information. Our model helps to understand when markets are most susceptible to imbalance-induced instability and the dynamic process of how markets digest order imbalance.
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