Jan

24

Anonymity, Signaling, and Collusion in Limit Order Books
Álvaro Cartea, University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance
Patrick Chang, University of Oxford - Oxford-Man Institute of Quantitative Finance
Rob Graumans, University of Oxford - Oxford-Man Institute of Quantitative Finance; Autoriteit Financiële Markten (AFM)
Date Written: January 03, 2025

A key feature in the design of a limit order book is the anonymity of limit orders. However, we analyze data with trader identification and find that market makers break the anonymity of limit orders. Market makers use limit orders with large volumes to signal themselves to other market makers to avoid trading with each other and to snipe retail limit orders. We explain the behavior of market makers with a model that considers competitive and collusive equilibria. The model shows that the behavior of market makers we observe in the data is consistent with that in a collusive equilibrium where market makers use signals to avoid sniping each other's limit orders. Signaling enables market makers to share the benign flow from retail limit orders, and to share the additional benign flow from impatient investors who otherwise would have traded with a retail investor’s limit order.

Asindu Drileba writes:

I wonder how the markets would change if order books were opaque.


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