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Electronic copy available at: http://ssrn.com/abstract =1193442 Liquidity shocks and order book dynamics ∗ Bruno Biais † and Pierre-Olivier Weill ‡ June 30, 2009 Abstract We propose a dynamic competitive equilibrium model of limit order trading, based on the premise that investors canno t monito r mark ets contin uously . W e study how limit order markets absorb transient liquidity shocks, which occur when a significant fraction of investors lose their willingness and ability to hold assets. We characterize the equilibrium dynamics of market prices, bid-ask spreads, order submissions and cancelations, as well as the volume and limit order book depth they generate. Keywords: Limit-order book, liquidity, bid-ask spread, search JEL Codes: G12, D83 ∗ Many thanks, for helpful discussions and suggestions, to Andy Atkeson, Dirk Bergemann, Dar- rell Duffie , Emman uel F arhi, Thierry Fouc ault, Christ ian Hellwi g, Hugo Hopenh ayn, Vivien L´ evy– Garboua, Johannes Horner, John Moore, Henri Pages, Jean Charles Rochet, Larry Samuelson, Jean Tirole, Aleh Tsyvinski, Juusso V¨ alim¨ aki, Dimitri Vayanos, Adrien Verdelhan, and Glen Weyl; and sem- inar participants at the Federal Reserve Bank of Minneapolis, UCLA Economics, Toulouse, LSE, LBS, the Banque de France Conference on Macroeconomics and Liquidity, UCSD Rady School of Business, the University of Minnesota Carlson School of Business, UCLA Anderson, Yale University theory and macroeconomic workshops, Harvard University, Loyola Marymount University, the FBF-IDEI Con- ference on Investment Banking and Financial Markets, Boston University, the 2009 NYSE-Euronext conference in Amsterdam, the 2009 conference on Information and Dynamic Mechanism Design in Bonn, and the 2009 Society for Economic Dynamics Meeting. Bruno Biais benefitted from the support of the “Financial Markets and Investment Banking V alue Chain Chair” sponsored by the F´ ed´ eration Bancaire Fran¸caise, and Pierre-Olivier Weill from the support of the National Science Foundation, grant SES-0922338. † Toulouse School of Economics (CNRS, IDEI), [email protected]. ‡ University of California Los Angeles and NBER, [email protected]. 1

Liquidity Shocks and Order Book Dynamics

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