Liquidity Cycles and Make/Take Fees in Electronic Markets
Résumé
We develop a model of trading in securities markets with two specialized sides: traders posting quotes ("market makers") and traders hitting quotes ("market takers"). Liquidity cycles emerge naturally, as the market moves from phases with high liquidity to phases with low liquidity. Traders monitor the market to seize profit opportunities. Complementarities in monitoring decisions generate multiplicity of equilibria: one with high liquidity and another with no liquidity. The trading rate depends on the allocation of the trading fee between each side and the maximal trading rate is typically achieved with asymmetric fees. The difference in the fee charged on market-makers and the fee charged on market-takers ("the make-take spread") increases in (i) the tick-size, (ii) the ratio of the size of the market-making side to the size of the market-taking side, and (iii) the ratio of monitoring costs for market-takers to monitoring costs for market-makers. The model yields several empirical implications regarding the trading rate, the duration between quotes and trades, the bid-ask spread, and the effect of algorithmic trading on these variables.