Information droughts on the limit order book

This paper studies a financial exchange in which liquidity may “dry up” endogenously. The drought is generated on a model of a limit order book under conditions of asymmetric information and an evolving fundamental. The book exhibits an equilibrium spread that is in steady state when it balances the rate that traders acquire information with the rate at which their stock of information decays. If the decay rate is too high, beliefs meanrevert almost everywhere to an uninformative prior, raising asymmetric information risk and motivating the departure of liquidity. A drought arises endogenously if traders lose confidence in their information stock. The drought has an element of stability because it reduces trading volume. Traders cannot learn enough from the reduced volume to motivate reentry. The result is interpreted as a limitation on information aggregation that is institutional. Department of Economics, University of California, Los Angeles (UCLA), Los Angeles, CA 90095. Particular thanks go to William Zame, Pierre-Olivier Weill, Christian Hellwig and Joseph Ostroy for mentoring on my dissertation committee. I thank Simon Board, Moritz Meyer-ter-vehn, Marek Pycia, the theory proseminar at UCLA, Hugo Hopenhayn and Edward Mehrez for their helpful comments and suggestions.