Abstract:

This paper examines informed traders' choices of supplying and demanding liquidity as well as market impact in electronic limit order markets. By endogenizing the direction of trade and the choice of order type, we find that informed traders exploit more often market orders than limit orders and they are more aggressive in the presence of a larger volatility; in general, conditional on the favorable realization of liquidation value, informed buyers and sellers are more aggressive than their uninformed counterparts respectively. We also show that both the volatility and the proportion of informed traders frustrate uninformed traders' willingness to participate in the market and their willingness to provide liquidity if they do. Total welfare of market participants is improved by informed trading but the informed traders gain at the cost of their uninformed counterpart’s welfare.