A Tale of Two Channels: Incorporating Private Information in Limit Order Market

Abstract

This study empirically investigates informed investors’ choice between demanding and supplying liquidity, and the incorporation of private information through both liquidity demanding and supplying channel of limit order market. By extending the structural model of Easley, et al. (1996) to allow informed traders supplying liquidity through price improving and at-the-quote limit orders, I find that supplying liquidity becomes the dominating choice for informed traders after 2003. As a result, private information incorporated through the liquidity supplying channel increases to near seven times of the amount from the liquidity demanding channel. As supplying channel private information will be revealed in limit order book without initiating transactions, it makes the order book more informative, reduces information asymmetry, and is not priced in asset return.