Automated Liquidity Provision and the Demise of Traditional Market Making

The model of Glosten and Milgrom (1985) is updated and it is found that the automated market maker transacts the majority of orders, sets prices that are more efficient, increases informed and decreases uninformed traders' transaction costs, and has no effect on volatility.

Abstract

Traditional market makers are losing their importance as automated systems have largely assumed the role of liquidity provision in markets. We update the model of Glosten and Milgrom (1985) to analyze this new world: we add multiple securities and introduce an automated market maker who prices order flow for all securities contemporaneously. This automated participant transacts the majority of orders, sets prices that are more efficient, increases informed and decreases uninformed traders' transaction costs, and has no effect on volatility. The model's predictions match very well with recent empirical findings and are difficult to replicate with alternative models.