Uncertain Market Making

Abstract

This paper argues that market makers’ presence is uncertain over any short time interval, as their operations are subject to shocks and constraints of, e.g., capital, technology, and attention. Such uncertain market making implies a random pricing equilibrium in a noise rational expectations framework. Implications for risk, liquidity, and efficiency are discussed. A structural model captures from data the predicted dispersion of random pricing. In 2014, the estimated dispersion is around 10 times of the average price impact, compared to only 2 times in the early 2000s. The evidence suggests deteriorated short-run order flow pricing efficiency in the U.S. equity market.