Direct quantitative evidence of the order-splitting hypothesis as the microscopic origin of long-range correlations in market order flow

Abstract

In financial markets, the market order sign exhibits strong persistence, widely known as the long-range correlation (LRC) of order flow; specifically, the sign correlation function displays long memory with power-law exponent γ, such that C(τ ) ∝ τ −γ for large time-lag τ . One of the most promising microscopic hypotheses is the order-splitting behaviour at the level of individual traders. Indeed, Lillo, Mike, and Farmer (LMF) introduced in 2005 a simple microscopic model of order-splitting behaviour, which predicts that the macroscopic sign correlation is quantitatively associated with the microscopic distribution of metaorders. While this hypothesis has been a central issue of debate in econophysics, its direct quantitative validation has been missing because it requires large microscopic datasets with high resolution to observe the order-splitting behaviour of all individual traders. Here we present the first quantitative validation of this LFM prediction by analysing a large microscopic dataset in the Tokyo Stock Exchange market for more than nine years. On classifying all traders as either order-splitting traders or random traders as a statistical clustering, we directly measured the metaorder-length distributions P (L) ∝ L −α−1 as the microscopic parameter of the LMF model and examined the theoretical prediction on the macroscopic order correlation: γ ≈ α − 1. We discover that the LMF prediction agrees with the actual data even at the quantitative level. Our work provides the first solid support of the microscopic model and solves directly a long-standing problem in the field of econophysics and market microstructure.