Impact of Informed Trading on Liquidity

Very Hard Equity Market Structure Market Microstructure

In the context of market microstructure, liquidity is a critical factor influencing trading strategies and price formation. It can be classified into two main types: immediacy and depth. Immediacy refers to the ability to execute trades quickly without affecting the asset's price significantly, while depth indicates the availability of buy and sell orders of varying sizes at different price levels.

Consider a theoretical framework where market participants have equal information and are executing trades on an electronic limit order book. An analysis is conducted to determine the implications of information asymmetry on implied liquidity measures, specifically focusing on how informed traders affect both immediacy and depth in such a market structure.

Based on this context, which of the following statements correctly describes an effect of informed trading on liquidity?

Informed trading enhances market depth by increasing the number of limit orders that are placed at various price levels.

Informed trading reduces immediacy as it causes adverse selection, leading to wider bid-ask spreads.

Informed trading has no impact on price volatility, as it only affects the quantity of trades.

Hint

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