DERA Working Paper: Automated Liquidity Provision

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.

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