Liquidity supply and adverse selection in a pure limit order book market

Abstract

This paper analyzes adverse selection costs and liquidity supply in a pure open limit order book market. We relax assumptions of the Glosten/Sandas modeling framework regarding marginal zero profit order book equilibrium and the parametric market order size distribution. We show that using average zero profit conditions considerably increases the empirical performance while a nonparametric specification for market order size combined with marginal zero profit conditions does not. A cross sectional analysis corroborates the finding that adverse selection costs are more severe for smaller capitalized stocks. We also find additional support for one of the central hypothesis put forth by the theory of limit order book markets, which states that liquidity supply and adverse selection costs are inversely related. Furthermore, adverse selection cost estimates based on our structural model and those obtained using popular model-free methods are strongly correlated. This indicates the robustness of the theory-based approach.