Liquidity Cycles and Make/Take Fees in Electronic Markets

T. FOUCAULT, O. Kadan, E. Kandel

The Journal of Finance

February 2013, vol. 68, n°1, pp.299-341

Departments: Finance, GREGHEC (CNRS)

Keywords: Maker/Taker Pricing, Algorithmic Trading, Latency, Monitoring, Liquidity Externalities

We develop a model of trading in which the speed of reaction to trading opportunities for liquidity suppliers (makers) and liquidity demanders (takers) is endogenous. In choosing their speed of reaction, traders face a trade-o¤ between the benefit of being first to seize a profit opportunity and the cost of attention required to be first to seize this opportunity. The model provides an explanation for the widespread adoption of maker/taker pricing (the di¤erentiation of trading fees between makers and takers), and yields several implications regarding the e¤ects of algorithmic trading on liquidity, volume, and welfare. The trading intensities of makers and takers reinforce each other, highlighting a new form of liquidity externalities. We show that data on durations between trades and quotes could be used to identify these externalities