Accounting for Strategic Response in Limit Order Book Dynamics

Abstract

The orders of traders in financial markets are typically stored in so-called limit order books. It is well understood that the mechanisms used to rank buy and sell orders affect the behavior of traders and ultimately market fundamentals. Research has focused on different design paradigms, alternative to the commonly used price-time priority, in the attempt to reduce volatility, maintain traded volumes and reduce toxic order flows. We here examine spread/price-time priority, introduced in [8], where the spread of two-sided orders contributes to the determination of the ranking. In contrast to previous simulation and numerical results, we account for the strategic response of traders. We consider different order aggression levels as pure strategies, and adopt a sound empirical game-theoretic analysis to analyze the market at equilibrium. Our results indicate that volatility is reduced by spread/price-time priority whereas the total trading volume is highly related to its spread weight: there is a sharp drop of trading volume when spread dominates the ranking over price. Our analysis shows that a $70\%$ ranking contribution of price and a $30\%$ ranking contribution of spread is a suitable setting that can lower the market volatility without decreasing trading volume. Our study confirms that spread/price-time priority is beneficial to financial markets, even when trader incentives are considered, while clarifying that its parameters need to be appropriately set.