Market Microstructure Invariance: A Dynamic

Equilibrium Model

Albert S. Kyle* Anna A. Obizhaeva

University of Maryland New Economic School
akyle@rhsmith.umd.edu aobizhaeva@nes.ru

First Draft: January 17, 2016

This Draft: March 15, 2018†

Abstract

We obtain invariance relationships in a dynamic infinite-horizon equilibrium model

with risk-neutral informed trading, noise trading, market making, and endogenous pro-
duction of information. Invariance scaling laws for bet sizes and transaction costs are de-
rived under the assumption that the effort required to generate one bet does not vary across
securities and time. Invariance scaling laws for pricing accuracy and market resiliency re-
quire the additional assumption that private information has the same signal-to-noise ra-
tio across markets. We show that prices follow a martingale with endogenously derived
stochastic volatility; volatility, pricing accuracy, and market resiliency are closely related to
each other. The model solution is derived in terms of the two state variables, stock price and
hard-to-observe pricing accuracy. Invariance makes these predictions operational by ex-
pressing them in terms of specific non-linear functions of easily observable variables such
as price, volume, and volatility.

Keywords: Market microstructure, invariance, liquidity, bid-ask spread, market impact, trans-
action costs, market efficiency, efficient markets hypothesis, pricing accuracy, resiliency, order
size.

* Albert S. Kyle has worked as a consultant for various companies, exchanges, and government agencies. He is a
non-executive director of a U.S.-based asset management company.
†
This paper was previously part of the manuscript “Market Microstructure Invariants: Theory and Empirical
Tests” (October 17, 2014).
 Market microstructure invariance is a new paradigm proposed by Kyle and Obizhaeva (2016)
and built on a set of ad hoc empirical conjectures. These conjectures lead to a number of non-
linear scaling laws that successfully explain a large part of variation exhibited by various mi-
crostructure characteristics in the data. Yet, an important question remains whether one can
rationalize invariance relationships theoretically by obtaining them within a fully-fledged equi-
librium model. In this paper, we derive invariance relationships as endogenous implications
of a dynamic model. We show how to make theoretical implications operational by adding the
assumptions that some deeper parameters, such as distribution of private information and av-
erage costs of producing it, are the same across time and assets.
We obtain invariance relationships in the model based on the following assumptions. The
unobserved fundamental value of the stock follows geometric Brownian motion. Informed and
noise traders arrive randomly, pay a fixed dollar cost to get a private signal about the funda-
mental value, and trade once. Each informed traders gets an informative signal. Each noise
trader obtains a “fake” signal, which has the same unconditional distribution as an informa-
tive signal but carries no information; noise traders believe themselves to be informed. The
number of noise traders is such that they turn over the outstanding share float at an exoge-
nously given rate. The number of informed traders adjusts endogenously so that these traders
expect to make zero profits, net of transaction costs and net of costs of acquiring signals. Taking
into account the perceived information content of their signals, each trader places one bet by
announcing to competitive risk-neutral market makers the quantity he wishes to trade. With-
out knowing whether the trader is informed or not, market makers update their beliefs and set
break-even prices.
We solve for the dynamic equilibrium, in which the number of informed traders, trading
strategies, market liquidity, returns volatility, and market resiliency are derived to be non-linear
functions of the two state variables. These state variables are current stock prices and pricing er-
rors, defined as the log-standard-deviation of prices from fundamental values. As in Kyle (1985),
the prices follow a martingale from the perspectives of market makers, while drifting towards
their estimates of fundamental value from the perspectives of informed traders. Although fun-
damental volatility is assumed to be constant, returns volatility turns out to be stochastic and
increasing in the size of the pricing error. A conditional steady state can be described as the situ-
ation, when returns volatility and fundamental volatility coincide, so that the rate at which new
fundamental uncertainty unfolds and the rate at which prices incorporate private information
are in balance.
As stock prices change, the market itself changes. When prices and market capitalization are
high, trading volume is high, traders arrive frequently and place large bets, market resiliency
is high, returns volatility may be higher than fundamental volatility, trading is incorporating

1
information into prices faster than fundamental uncertainty is unfolding, the pricing error is
shrinking, the market is becoming more liquid, and the price dynamics quickly converges to
the steady state. When prices and market capitalization are low, trading volume is low, traders
arrive infrequently and place small bets, market resiliency and returns volatility are low, trading
is not incorporating information into prices as fast as fundamental uncertainty is unfolding,
the pricing error is widening, the market is becoming less liquid, and the price dynamics may
remain far from the steady state for an extended periods of time.
Our model highlights the difference between two definitions of market efficiency. On the
one hand, our markets are efficient in the sense that prices follow a martingale, as discussed by
Fama (1970) and LeRoy (1989). On the other hand, our markets differ in terms of endogenous
pricing accuracy and pricing errors, which measure the degree of market efficiency according to
Black (1986). In our model, pricing error variance is inversely proportional to market resiliency
and the number of bets. Since market resiliency may be easier to identify empirically than hard-
to-observe pricing errors, our paper suggests an indirect way to measure market efficiency.
The presented solution is elegant, but impracticable, because it is almost impossible to test
its predictions in practice. In fact, predictions are stated in terms of the two state variables.
While it is easy to observe prices, it is hard to observes another state variable pricing accuracy,
because it is difficult (or even impossible) to know where fundamental value is and how far
prices are usually from fundamentals. This failure to provide a clear operational guidance for
empirical research is unfortunately a common feature of many theoretical models. We show
how the paradigm of market microstructure invariance may help to resolve this problem by
emphasizing importance of practical implementation.
Broadly speaking, market microstructure invariance is the idea that financial markets are in
some fundamental sense similar to each other, except they operate at different pace. In active
liquid markets, business time runs fast; in inactive illiquid markets, business time runs slowly.
The business time may be hard to observe, but it is related to the speed with which bets, or new
investment ideas, arrive to the marketplace. In our model, the number of traders and therefore
the number of bets is an endogenous variable, constantly changing with any changes of the
state variables.
The trick in deriving operational implications is then (1) to express them in terms of eas-
ily observable variables such as price, volume, and volatility, and (2) to think more carefully
about the values of what parameters may be approximately constant across assets and time
due to some deeper economic rationales. In our model, these “constants” are the average un-
conditional dollar cost of obtaining a private signal (which values may be equalized by financial
professionals optimally allocating scarce intellectual resources across markets) and the shape
of normalized information distribution (e.g., normal pr log-normal distributions of private sig-

2
nals).
We prove ad hoc empirical conjectures, upon which Kyle and Obizhaeva (2016) build invari-
ance paradigm. We prove the first hypothesis of bet size invariance saying that the distribution
of the dollar risk transferred by bets is the same when measured in business time. We also prove
the second hypothesis of transaction costs invariance saying that the expected dollar transac-
tion cost is the same function of the dollar risks that bets transfer in business time. Under
the additional hypothesis of constant informativeness of signals, we derive two new invariance
principles. First, pricing accuracy invariance says that pricing accuracy—defined as the recip-
rocal of the standard deviation of the log-distance between the market price and fundamental
value—is invariant across markets if its reciprocal (pricing error) is scaled by returns volatility
per unit of business time. Second, market resiliency invariance says that market resiliency, de-
fined as the rate at which uninformative shocks to prices (resulting from noise trades) decay,
or—equivalently—the rate at which prices converge towards fundamental value, is invariant if
it is measured per unit of business time.
We also derive a number of non-linear scaling laws, summarized in Theorem 2 (see equa-
tions (58)). These are scaling laws for bet size, number of bets, market depth, market liquidity,
pricing accuracy, and market resiliency. They identify links between various microstructure
characteristics—such as bet size, number of bets, market depth, market liquidity, pricing ac-
curacy, and market resiliency—and easily observable variables of trading volume and returns
volatility raised into specific powers of one-third and two-thirds. Under invariableness of a
couple of deep parameters, these are operational and empirically testable predictions of our
model. To the extent that the empirical observations deviate from invariance—perhaps due
to market frictions—invariance provides a natural benchmark for explaining how one market
differs from another.
Our structural model helps to clarify the intuition behind invariance relationships and the
seemingly obscure exponents of one-third and two-thirds. The intuition boils down to the ob-
servation that while both volume and returns variance increase linearly with the number of
bets, returns volatility increases at a slow pace, linearly only with the square root of the num-
ber of bets. For example, suppose returns volatility remains constant and equal to fundamental
volatility, but market capitalization changes due to price changes. Then, when market capital-
ization is high, more traders execute bets, trading volume is high, the market becomes more
efficient in the sense that the distance between prices and fundamentals shrinks, and market
depth increases. Traders must execute bets of larger sizes in order to make enough profits to
cover the same dollar costs of producing a private signal. Returns volatility per bet and the log-
distance between prices and fundamentals decreases only half as much as the rate of bet arrival
goes up. In other words, the market efficiency adjusts to changes in trading volume, but only

3
slowly. Thus, trader must scale up the size of their bets by half as much as an increase in the
arrival rate of bets. This implies a one-to-two ratio between an increase in the size of bets and
their number. Since trading volume is the product of the number of bets and their average size,
the number of bets increases linearly with two-thirds of trading volume and their average size
increases linearly with one-third of trading volume.
The proof of many invariance relationships does not have to rely any atypical assumptions.
In fact, they are simply implications of several general properties, which are likely to be shared
by many models of market microstructure (see equations (50)–(53)). First, trading volume is
defined as the sum of all bets. Second, order flow moves prices and induces returns volatility;
unconditional long-term price impact is linear in the information content of bets. Third, the
dollar cost of acquiring an informative signal—which in equilibrium equals the dollar price-
impact cost of the bet—is the same across assets and time. Fourth, the distributions of bet size
and signals have the same shape across markets. The general nature of these assumptions sug-
gests that most likely the derived scaling laws are not only features of the particular equilibrium
model, but also universal properties of financial markets. Not surprisingly, Kyle and Obizhaeva
(2017) are able to derive similar invariance relationships using a general methodology of di-
mensional analysis and imposing the restriction related to leverage neutrality.
A number of recent empirical studies provide evidence in favor of invariance predictions.
Kyle and Obizhaeva (2016) find scaling laws for sizes and trading costs of portfolio transition
orders executed in the U.S. stock market. Kyle and Obizhaeva (2017) document scaling laws
for quoted bid ask spreads and number of trades in data for Russian and U.S. stocks. Kyle,
Obizhaeva and Tuzun (2010) discuss scaling laws for number of trades and their sizes in tick-
by-tick transaction data in the U.S. stock market. Bae et al. (2014) document scaling laws in the
number of switching points in transactions in the South Korean stock market. Kyle et al. (2010)
find scaling laws in the number of news articles about the U.S. firms. It is remarkable how well
predictions of our theoretical model match the data, when they are formulated in “invariance”
form. The same invariant structure hidden in the data seems to be revealed by these studies
examining the data from different angles.
Our model blends together several traditional strands of the market microstructure litera-
ture. Like Kyle (1985), we assume linear trading intensity, linear price impact, normally dis-
tributed random variables, and zero-profit market makers. Like Glosten and Milgrom (1985),
we assume orders arrive sequentially and are therefore processed by market makers one at a
time. Like Treynor (1971) and Black (1986), we assume that noise traders trade on uninforma-
tive, fake signals; noise traders believe they are informed traders even though they are trad-
ing on noise. The model differs from Kyle (1985) in that the assumed linear trading strategies
and pricing updates are only approximately, not exactly, optimal. Unlike Glosten and Milgrom

4
(1985) and Back and Baruch (2004), we assume that traders may choose to buy or sell any quan-
tity, not just one round lot. Unlike Kyle, Obizhaeva and Wang (2017), we assume that traders do
not smooth out their trades over time but instead trade only once. The issues discussed in our
paper are relevant for all theoretical models regardless of their specific modelling assumptions.
This paper is structured as follows. Section 1 presents a dynamic model. Section 2 discusses
its solution. Section 3 shows how to derive invariance relationships in the context of this model.
Section 4 discusses continuous-time limit, comparison with other microstructure models, ro-
bustness of assumptions, and other issues. Section 5 concludes. Proofs are in A.

1 A Dynamic Model of Trading

This section describes an equilibrium dynamic model of sequential speculative trading. To
make clear the distinction between endogenous variables and exogenous parameters, all exoge-
nous parameters are assumed to be constants, while all endogenous parameters are assumed
to be functions of time.

Fundamental Value and Prices. There are three types of traders: informed traders, noise
traders, and market makers. Trading takes place until some distant date at which all traders
receive a payoff equal to the fundamental value F (t ) of the risky asset. The fundamental value
evolves over time due to continuous un-modeled changes in production processes, consumer
tastes, costs of materials, prices of outputs, competitor strategies, and other market conditions.
Let F (t ) follow a geometric Brownian motion with fundamental volatility σF :

F (t ) ∶= F 0 exp (σF B (t ) − 21 σ2F t ) , (1)

where B (t ) denotes a standardized Brownian motion with B (t + h ) − B (t ) ∼ N (0, h ) for t ≥ 0

and h ≥ 0, B (0) is normally distributed, and the initial value F 0 is a known constant. The term
1 2
2 σF t adjusts for convexity so that the fundamental value follows an exponential martingale and
satisfies E [F (t + s ) ∣ F (u ) ∶ u ≤ t ] = F (t ) for s ≥ 0.1 Let N denote outstanding shares. The stock
is exchanged for a risk-free numeraire asset which earns no interest.
1
We choose to model fundamentals as the geometric Bronwnian motion rather than the Brownian motion as
in many other microstructure models. Both approaches will generate invariance relations, since the meta-model
equations are largely the same. The disadvantage of our approach is that we need to rely on some approximations,
which we believe are sufficiently close to exact non-linear solutions. The important advantage of our approach is
that our model has much more realistic properties. For example, returns volatility as well as pricing accuracy do
not change much following large changes in market capitalization (due to changes in prices in our model). Given
that our goal is to outline a realistic model of financial markets, we chose to use the geometric Brownian motion.
Our modelling approach is also consistent with leverage neutrality, discussed in Kyle and Obizhaeva (2017).

5
 As informed traders and noise traders arrive into the market and anonymously place only
buy and sell bets at discrete, perhaps random, and unequally-spaced times, the price P (t )
changes to reflect new information. Risk-neutral competitive market makers clear the mar-
ket by taking the other side of bets and setting the market price to be the best estimate of the
fundamental value given a history of the bet flow. To simplify notation, we use the following
conventions for time. Let t (not t n ) denote an arbitrary bet arrival time. When a bet arrives at
time t , the price jumps from P (t ) just before the bet arrives to P (t + ∆t ) just after the bet arrives
(not from P (t n− ) to P (t n+ )). The time interval ∆t between a bet arriving at time t and the next bet
arriving at time t + ∆t may be either stochastic or nonstochastic, conditional on information at
time t .
Let Et [. . .] denote the expectation operator conditional on market makers’ information at
date t , excluding information about the size of a bet arriving at time t itself. The observable
price P (t ) is the market’s best estimate of the fundamental value,

P (t ) = Et [F (t )] . (2)

For the purpose of calculating the price, instead of focusing on the market’s estimate of the
fundamental value itself, it is more convenient to think about the estimates of the Brownian
motion B (t ), in terms of which the fundamental value is defined in equation (1). Let B̄ (t )
denote the market’s conditional expectation of B (t ) just before time t :

B̄ (t ) ∶= Et [B (t )] . (3)

Suppose that the conditional error B (t ) − B̄ (t ) has approximately a normal distribution with a
mean of zero and a time-varying variance Σ(t )/σ2F :

σF (B (t ) − B̄ (t )) ∼ N (0, Σ(t )) . (4)

The numeric analysis in Appendix A.1 suggests that for empirically reasonable parameter val-
ues, our approximate solutions are very close to what the exact solutions would be. Given our
assumption about the conditional error being approximately a normal, we have

P (t ) = Et [F (t )]
= F0 exp (σF B̄ (t )) exp (σF (B (t ) − B̄ (t )) − 12 σ2F t ) (5)
= F0 exp (σF B̄ (t ) + 12 Σ(t ) − 21 σ2F t ) .

The law of iterated expectations implies that P (t ) is a martingale. Given Σ(t ), this equation

6
shows that P (t ) and B̄ (t ) are informationally equivalent, and therefore the history of the bet
flow is informationally equivalent to the history of prices.
The variable Σ1/2 (t ) has the interpretation as a log-percentage pricing error. Prices fluctuate
around fundamentals. If prices are above fundamentals, then prices will tend to decrease over
time towards fundamentals, as trading gradually incorporates private information into prices.
If prices are below fundamentals, then informed trading will tend to make prices increase over
time in the direction of fundamentals. From equations (1) and (5), we find that Σ1/2 (t ) mea-
sures the standard deviation of the log-difference between F (t ) and P (t ):

F (t ) 1 /2
Σ1/2 (t ) = ( Vart [ln ( )]) . (6)
P (t )

Its reciprocal Σ−1/2 (t ) can be then interpreted as a measure of pricing accuracy. The further
prices deviate from fundamental value, the less accurate they are, and the bigger is the pricing
error and the smaller is the pricing accuracy.
Let resiliency ρ (t ) be the mean-reversion parameter (e.g., per calendar day) measuring the
speed with which a random shock to prices—resulting from execution of an uninformative
bet—dies out over time, as informative bets drive prices back towards fundamental value. The
half-life of an uninformative shock to prices is equal to ρ −1 (t ) ln(2). We will show later that the
concept of pricing errors is closely related to the concept of resiliency. They are two sides of the
same coin; resiliency ρ (t ) is greater in markets with higher pricing accuracy Σ−1/2 (t ).

Informed Traders. Informed traders arrive into the market at endogenous rate γI (t ). They
observe the history of price changes and the current price, which allow them to infer the current
market’s estimate B̄ (t ) and the scaled error variance Σ(t ). Upon arrival at time t , each informed
trader pays a fixed cost c I to observe an informative private signal i I (t ) about how much the
current price deviates from fundamentals B (t )− B̄ (t ) and then places one bet; the other side of
each bet is taken by market makers. Eventually, the bet is liquidated at the fundamental value
of the asset.
We model private signals of informed traders as,

τ 1 /2
i I (t ) ∶= (B (t ) − B̄ (t )) + Z I (t ), (7)
Σ1/2 (t ) σ−
F
1

where τ is an exogenous constant parameter of precision and the noise term Z I (t ) is distributed
N(0, 1 − τ). The noise term is distributed independently from both (B (t ) − B̄ (t )) and the history
of prices prior to the arrival of the signal. We scale precision by the factor Σ1/2 (t ) σ−1
F , represent-
ing the standard deviation of B (t ) − B̄ (t ) in equation (4), and assume that Vart [ Z I (t )] = 1 − τ.

7
This makes a signal to have a variance of one ( Vart [i I (t )] = 1) and make τ/(1 − τ) to be a signal-
to-noise ratio. Without such scaling, this ratio would vary with pricing error.2 As pointed out by
Kyle, Obizhaeva and Wang (2017), this form of modeling information is consistent with dynamic
settings. As we show below, it is also consistent with invariance relationships if τ in equation (7)
is relatively constant across time and assets.
Each informed trader constructs an estimate of the fundamental value using the private
signal i I (t ) and the history of prices, including the most recent price. He updates his estimate
of fundamental value from his prior B̄ (t ) to B̄ (t ) + ∆B̄ I (t ):

τ1/2 Σ1/2 (t )
∆B̄ I (t ) ∶= Et [B (t ) − B̄ (t ) ∣ i I (t )] ≈ i I (t ). (8)
σF

The notation Et [. . . ∣ i I (t )] indicates conditioning both on public information (history of bets or

prices) before t and conditioning on the signal i I (t ). The subscript I on ∆B̄ I (t ) indicates that
updating is done given the information set of the informed trader. The updating by an informed
trader is different from the updating by market makers, because the informed trader assumes
that his bet is informed (with probability one) while market makers do not know whether a
bet is informed or uninformed, so they incorporate into their updating rule the possibility that
a bet comes from a noise trader. Based on the approximating assumption that B (t ) − B̄ (t ) is
normally distributed, equation (8) can be derived by regressing B (t ) − B̄ (t ) on the signal i I (t )
from equation (7) and replacing the variance of B (t ) − B̄ (t ) with Σ(t )/σ2F .
If the informed trader’s information were to be fully incorporated into the price, the price
would change by Et [F (t ) − P (t ) ∣ ∆B̄ I (t )]. Because the geometric Brownian motion assump-
tion makes this price change an exponential function of ∆B̄ I (t ), the price change is theoreti-
cally nonlinear. Nevertheless, we assume that the informed trader approximates this nonlinear
change with a linear function of ∆B̄ I (t ):

Et [F (t ) − P (t ) ∣ ∆B̄ I (t )] ≈ P (t ) σF ∆B̄ I (t ). (9)

The proof is in Appendix A.2. In dollars-per-share, the difference between fundamental value
and price is equal to a product of P (t ) and σF ∆B̄ I (t ). The informed trader does not incor-
porate all of it into prices, because he act strategically as a monopolist on his private informa-
tion. Suppose a fraction θ of this information is incorporated into prices, then prices move by
θ Et [F (t ) − P (t ) ∣ ∆B̄ I (t )].
Market makers provide liquidity by taking the other side of a bet. They accommodate a bet
2
For example, if i I (t ) ∶= τ1/2 (B (t ) − B̄ (t )) + Z I (t ), then a signal-to-noise ratio would be equal to
τ Σ (t ) σ−
1/2
F /(1 − τ) and would depend on Σ
1 1/2
(t ) and σF , i.e, traders will be learning “more” when Σ1/2 (t ) is
large and σF is small. In our setting, we keep constant the amount of information arriving each time.

8
at adjusted prices P (t ) + λ(t ) Q (t ), where the price adjustment is linear in Q (t ) and λ(t ) is an
endogenous parameter measuring linear price impact.
To measure transaction costs, informed traders can calculate the implementation short-
fall of Perold (1988) by comparing the actual execution price and pre-trade benchmark. Let
C B (Q, t ) denote the total dollar price impact cost of executing a bet of Q shares at time t :

C B (Q, t ) ∶= λ(t ) Q 2 . (10)

Let C̄ B (t ) denote the unconditional expected dollar price impact cost of executing a bet at time
t without conditioning on bet size:

C̄ B (t ) ∶= λ(t ) Et [Q 2 (t )] . (11)

If the informed trader trades Q (t ) shares at price P (t ), then his unconditional expected “paper-
trading” profits, denoted π̄I (t ), are equal to

π̄I (t ) ∶= Et [(F (t ) − P (t )) Q (t )]. (12)

The informed trader chooses an order size Q (t ) to maximize his expected profits (F (t ) −
P (t )) Q (t ) net of market impact costs λ(t ) Q 2 (t ) conditional on observing the signal i I (t ) or,
equivalently, on observing ∆B̄ I (t ),

Q (t ) = arg max Et [(F (t ) − P (t )) Q − λ(t ) Q 2 ∣ ∆B̄ I (t )]. (13)

Q

Using equation (9), this further yields the solution for the equilibrium quantities traded:

1 Et [F (t ) − P (t ) ∣ ∆B̄ I (t )] 1 P (t ) σF ∆B̄ I (t )
Q (t ) = = . (14)
2 λ(t ) 2 λ(t )

This is the solution for the optimal trade-size optimization problem of a risk-neutral monop-
olistic informed trader, who optimally incorporates half of his information into prices. More
generally, the optimal trade size of the informed trader can be written as,

P (t ) σF ∆B̄ I (t )
Q (t ) = θ , (15)
λ(t )

where we replace 1/2 in equation (14) with the exogenous parameter θ.

As a benchmark, one can assume θ = 1/2, the value implied by risk neural profit optimiza-
tion (13). More generally, our definition of equilibrium instead assumes θ to be an arbitrary

9
exogenous value such that 0 < θ < 1, so that the bet incorporates a fraction θ of its information
content and prices change by θ P (t ) σF ∆B̄ I (t ). This approach accommodates the possibility
that informed traders are risk averse, in which case θ < 1/2 might be optimal; it also accommo-
dates the possibility of information leakage, in which case θ > 1/2 might be optimal. We will
show that the invariance results derived below depend only on the fact that θ is some constant,
not that θ has the specific value 1/2.
Using the expression for ∆B̄ I (t ) in equation (8), this trading rule (15) can be written as

θ τ 1 /2
Q (t ) = β(t ) i I (t ), where β( t ) = P (t ) Σ1/2 (t ). (16)
λ(t )

The arrival rate of informed traders is determined later based on the break-even condition.

Noise Traders. Noise traders arrive into the market at endogenous rate γU (t ). Each of them
pays some fee and observes a fake random signal with the same unconditional distribution,
iU (t ) ∼ N(0, 1), as an informed trader’s signal i I (t ) in equation (7), but with no information
about the difference between the current price and fundamental value B (t ) − B̄ (t ),

iU (t ) ∶= ZU (t ) (17)

with Vart [ ZU (t )] = 1. The signal is noise in the sense that iU (t ) is distributed independently
from the error B̄ (t ) − B (t ) and the history of prices.
Noise traders believe, incorrectly, that they are informed traders and “optimize” their trading
by choosing the same trading intensity β(t ) as informed traders. The sizes of noise traders’ bets

Q ( t ) = β( t ) i U ( t ) (18)

have the same unconditional distribution as the sizes of informed traders’ bets in equation (16).
We use the notation Q (t ), without a subscript I or U , to indicate a random order based on a
signal i (t ) that could either be informed or uninformed signal i I (t )) or iU (t ), respectively.
The arrival rate of noise traders is set to achieve an exogenously specified share turnover
rate, denoted η, of outstanding shares N . Thus, expected share volume from noise traders η N
and the total volume V (t ) satisfy

γU (t ) Et [∣Q (t )∣] = η N (19)

and
γ(t ) Et [∣Q (t )∣] = V (t ), where γ(t ) ∶= γI (t ) + γU (t ). (20)

10
Market Makers. Zero-profit, risk-neutral, competitive market makers are assumed to set prices
such that the price impact of anonymous trades Q (t ) by either informed or noise traders makes
the price equal to the conditional expectation of the fundamental value. We assume that market
makers use the price-adjustment rule linear in bet size,

∆P (t ) ∶= Et [F (t ) − P (t ) ∣ Q (t )] = λ(t ) Q (t ). (21)

Market maker knows that a bet Q (t ) is drawn from a mixture of normal distributions. If
market makers could observe whether a bet was placed by an informed trader or noise trader,
then their inference will be simple. They would multiply the price impact of an informed bet
λ(t ) Q (t ) by 1/θ, since an informed bet incorporates only a fraction θ of its information content
into prices, and they would multiply the price impact of a noise bet λ(t ) Q (t ) by zero, since a
noise bet has no information content. The probability of an informed bet is γU (t )/γ(t ), and
the probability of a noise bet is γU (t )/γ(t ). In equilibrium, the expected price impact of a bet,
unconditional of whether it is informed or noise bet, must therefore be equal to

γI (t ) 1 γU (t )
∆P (t ) = λ(t ) Q (t ) = λ(t ) Q (t ) × + λ(t ) Q (t ) × 0. (22)
γ(t ) θ γ(t )

For example, if θ = 1/2, then the price adjustment is equal to the product of the probability of
informed bet γI (t )/γ(t ), price impact λ(t ), and doubled the bet size 2Q (t ), where a factor
of 2 is included to undo the strategic monopolistic reduction in quantities traded by each of
informed traders. This price updating is similar to filtering of market makers in Back and Baruch
(2004).
The equilibrium has an interesting nonintuitive knife-edged property with respect to how
market makers respond to adverse selection. As we discuss later, this property is not unique for
our model, it is common for some other microstructure models, including the continuous-time
model of Kyle (1985). Since price impact results from adverse selection, one might expect the
price impact parameter λ(t ) to be determined by filtering equation (22), which describes the
adverse selection problem faced by market makers. Instead, λ(t ) and Q (t ) enter both sides
of this equation linearly and cancel out. This implies that the market makers’ updating rule
does not determine market depth 1/λ(t ) but instead imposes the following restriction on the
fractions of informed traders γI (t )/γ(t ) and noise traders γU (t )/γ(t ):

γI (t ) γU (t )
= 1− = θ. (23)
γ(t ) γ(t )

This equation is obtained directly from equation (22). The endogenously determined fraction

11
of traders who are informed turns out to be equal to the exogenous constant θ! In the baseline
case of θ = 1/2, the number of informed traders must be exactly equal to the number of noise
traders.
There is simple intuition for this result. If the fraction of informed traders were greater
than θ, then market makers would make losses regardless of the level of the market depth they
choose. Indeed, suppose market makers reduce depth by increasing λ(t ) in response to making
losses. Then both informed traders and noise traders reduce the sizes of their bets exactly pro-
portionally with λ(t ), as can be seen in equation (15). The amount of adverse selection in the
order flow does not change. Market makers are making proportionally smaller losses—but still
making losses—and informed traders making proportionally smaller trading profits—but still
making profits. The trading profits of informed traders fall below the cost of acquiring private
information; informed trading becomes unprofitable, informed traders exit the market, and the
ratio of informed traders to noise traders decreases. Eventually, the fraction of informed traders
falls to θ, at which point market makers break even regardless of the market depth chosen. Sim-
ilar arguments show that if the fraction of informed traders were smaller than θ, then market
makers would be making profits regardless of market depth they choose.
Thus, market makers instead choose the level of market depth 1/λ(t ) such that informed
traders’ profits cover price impact costs and the costs c I of acquiring private information.

Break-Even Conditions for Informed Traders and Market Makers. The solution should sat-
isfy two break-even conditions. The arrival rate of informed traders is chosen so that their ex-
pected paper trading profits from trading on a signal π̄I (t ) are equal the sum of expected trans-
action costs C̄ B (t ) and the exogenously constant cost of acquiring private information c I in the
first place:
π̄I (t ) = C̄ B (t ) + c I . (24)

This break-even condition for informed traders ultimately yields the rate γI (t ) at which in-
formed traders place bets.
Consider next the break-even condition for market makers. Equation (15) implies that the
unconditional expected dollar price impact cost of a bet by an informed or noise trader is given
by
C̄ B (t ) = λ(t ) Et [Q 2 (t )]. (25)

Bets by noise traders have the same expected impact cost as bets by informed traders, since
they are indistinguishable from informed bets from the perspective of market makers.
As in Treynor (1971), the expected losses market makers incur trading with informed traders
γI (t )(π̄I (t ) − C̄ B (t )) must on average be equal to their expected gains from trading with noise

12
traders γU (t ) C̄ B (t ). This implies

γI (t )
C̄ B (t ) = π̄I (t ). (26)
(γI (t ) + γU (t ))

The expected dollar price impact cost C̄ B (t ) that market makers earn by providing liquidity
must be equal to the product of the probability that a trader is informed, γI (t )/(γI (t )+ γU (t )),
and the expected dollar paper trading profits π̄I (t ) of an informed trader that market makers
lose to them.
Figure 1 illustrates the intuition. First, informed traders incorporate strategically only a frac-
tion θ of their information into prices by trading Q (t ), and the price jumps by θ Et [F (t )− P (t ) ∣
Q (t )] equal to θ P (t )σF ∆B̄ (t ); informed traders pay transaction costs C̄ B (t ) and expect to
make π̄I (t ) − C̄ B (t ) as the price gradually converges to expected fundamental value Et [F (t ) ∣
Q (t )] over time due to the subsequent trading of other informed traders. These profits are re-
alized at some distant date when the game ends and all positions are liquidated at the expected
fundamental value F (t ). Second, noise traders execute orders which also incur expected dollar
transaction costs C̄ B (t ), but they lose money since, on average, the price eventually converges
back to its initial level after their trades.
We define next several variables that characterize trading in the described market.

Liquidity Measure L (t ). Our main measure of illiquidity 1/L (t ) quantifies the average trans-
action costs for the market. It is equal to the average dollar cost of executing bets C̄ B (t ), defined
in equation (25), divided by the average bet size,

1 C̄ B (t )
∶= . (27)
L (t ) Et [∣P (t ) Q (t )∣]

This dimensionless quantity measures the dollar-volume-weighted expected price impact cost
of executing a bet as a fraction of the expected dollar value traded. For example, if the average
dollar cost of executing bets is $2000 and the average bet is one million dollars, then 1/L (t ) is
equal to 20 basis points. This measure is important in market microstructure invariance.

Volume V (t ). Equations (19), (20), and (23) imply that, in terms of exogenous variables, share
volume V (t ) constitutes a constant fraction of shares outstanding N :

ηN
V (t ) = . (28)
1−θ

13
 Figure 1: Intuition for the Model.

P = lQ
v

PsF B
v

p I CB informed trade
jPsF B
v

CB /2

CB /2 noise trade

Q = j/lPsF B
v

The figure illustrates price dynamics in response to arrival of a bet. The horizontal
axis measures the size of a bet Q (t ), and the vertical axis represents its price impact
∆P (t ) = λ(t )Q (t ). The trader executes Q (t ) = θ /λ(t ) Et [F (t )− P (t ) ∣ Q (t )], where
the perceived difference between fundamental value and price is Et [F (t ) − P (t ) ∣
Q (t )] = P (t )σF ∆B̄ (t ), and a fraction θ of this gap is incorporated into prices. After
informed bets, the price continues to increase to fully incorporate the information
content of the bet into prices. After noise bets, the price reverses to its initial level.
Both noise and informed traders pay C B (Q, t ) as market impact costs to market
makers, but informed traders also earn trading profits of π̄I .

Although V (t ) is a constant and not a function of time, it is written as a function of time to be

consistent with our notational convention that all endogenous variables are written as func-
tions of time and all exogenous parameters are constants.

Volatility σ(t ). So far, our model has been agnostic about the probability distribution of ∆t ,
i.e., the waiting time from one bet to the next. One reasonable assumption is that the waiting
time until the arrival of the next bet is an exponential distribution with mean 1/γ(t ). Another
reasonable assumption is that the waiting time until the arrival of the next bet is the condition-
ally non-stochastic constant ∆t = 1/γ(t ). Either assumption implies

1
Et [∆t ] = . (29)
γ(t )

14
The model holds regardless of which assumption we use.3 Market microstructure invariance,
which we discuss later, implements the intuition that the expected arrival rate of bets γ(t ) sets
the pace of business time in the market. Markets differ due to differences in speed with which
trading evolves.
Let σ2 (t ) denote the instantaneous returns variance of P (t ). Since one bet arrives on aver-
age during the interval of the length ∆t and the price is a martingale, the log-variance of inno-
vations in P (t ) resulting from one bet Q (t ) arriving at t to the next bet arriving in expectation
at date t + ∆t is given by

P (t + ∆t ) − P (t ) λ2 (t ) Et [Q 2 (t )]
σ2 (t ) Et [∆t ] ∶= Vart [ ]= = θ 2 τ Σ(t ), (30)
P (t ) P 2 (t )

where we use equation (16) to prove the last equality. If ∆t is small, then σ2 (t ) Et [∆t ] is ap-
proximately equal to the log returns variance Vart [ln (P (t + ∆t )/P (t ))]. This further implies
that bet arrival rate γ(t ) and returns variance σ2 (t ) are related by

1 σ2 (t )
γ(t ) = = 2 . (31)
Et [∆t ] θ τ Σ(t )

Trading Activity W (t ). In addition to share volume and notional (dollar) volume, we intro-
duce another measure of market activity. Following Kyle and Obizhaeva (2016), we define trad-
ing activity W (t ) as the product of dollar volume and volatility:

W (t ) ∶= P (t ) V (t ) σ(t ). (32)

It measures the aggregate amount of risk transferred by trading in a given calendar day. It is
equal to the standard deviation of the dollar change in the mark-to-market value of the entire
volume traded; this is an empirical measure of the rate at which the market transfers risks. Since
price, volume, and volatility are relatively easy to observe, the trading activity W (t ) is relatively
easy to observe as well.
Trading activity is an attractive measure of risk transfer for several reasons. It helps to take
into account that assets may differ in how risky they are. In low-risk assets even a large dol-
lar volume may ultimately correspond only to insignificant amount of risk transferred. Unlike
3
Yet, a third possibility is to assume θ = 1/2 and additionally assume that a pair of bets, one informed and
one uninformed, arrive simultaneously at intervals ∆t = 2/γ(t ). The market makers observe the sum of the two
bets, not each bets individually. Under this batching assumption, the log pricing error σF (B (t ) − B̄ (t )) and the
summed bets Q I (t ) + QU (t ) become jointly normally distributed. This makes linear projections exactly the same
as conditional expectations, not an approximation as has been assumed so far. We do not use this approach in
this paper because we believe the difference between linear projections and exact conditional expectations to be
economically negligible.

15
share volume V (t ), the trading activity is neutral with respect to splits. Unlike dollar trading
volume P (t )V (t ) and share volume V (t ), trading activity W (t ) is leverage neutral. If the firm
increases its leverage by paying out a debt-financed cash dividend per share that is equal to half
of the stock price, then the value of the stock halves and its return volatility σ(t ) doubles. Since
dollar volume P (t )V (t ) halves, the trading activity W (t ) remains unchanged. The concept of
leverage neutrality is further discussed in Kyle and Obizhaeva (2017).

Resiliency ρ (t ). When a new bet arrives and new information gets reflected in changes of
market makers’ estimates ∆B̄ (t ), the past pricing error B (t ) − B̄ (t ) decays. Market resiliency
ρ (t ) is the rate at which past pricing errors decay. Assuming normality makes conditional ex-
pectations linear and so resiliency ρ (t ) can be defined from the linear regression of innovations
in the pricing error ∆B (t ) − ∆B̄ (t ) on its most recent level B (t ) − B̄ (t ),

Et [∆B (t ) − ∆B̄ (t ) ∣ B (t ) − B̄ (t )] = −ρ (t ) Et [∆t ] (B (t ) − B̄ (t )) . (33)

The regression coefficient ρ (t ) in this equation satisfies

1 Covt [∆B (t ) − ∆B̄ (t ) , B (t ) − B̄ (t )] Covt [∆B̄ (t ) , B (t ) − B̄ (t )] θ2 τ

ρ (t ) = − = = .
Et [∆t ] Vart [B (t ) − B̄ (t )] Et [∆t ] Vart [B (t ) − B̄ (t )] Et [∆t ]
(34)
The covariance in the numerator is calculated using a filtering equation similar to equation (8),
adjusted for the probability θ of observing an informed signal (7). The variance in the denom-
inator is calculated based on equation (4). The last equation shows how resiliency ρ (t ) relates
to bet arrival rate γ(t ) and thus returns volatility.

Market Microstructure Invariance as Empirical Hypotheses. The main purpose of our paper
is to show that market microstructure invariance can arise endogenously in the equilibrium
model. We next briefly review the main assumptions of market microstructure invariance using
notations of our model.
In the paradigm of invariance, it is assumed that traders play similar trading games, but in
different markets these games evolve at different pace. The rate of bet arrivals γ(t ) sets the
business-time clock which is specific for each market. In an active, liquid market, bets arrive
at a fast rate; in a slow, inactive market, bets arrive at a slow rate. The starting point for market
microstructure invariance is a set of two empirical conjectures about distributions of bet sizes
and transaction costs functions in these trading games.
The first hypothesis of bet size cost invariance says that the probability distribution of the
dollar risk I (t ) transferred by a bet Q (t ) is invariant, if the risk is measured in dollars and the

16
time is counted by a clock which ticks at the expected rate of arrival of bets. Let I ∗ denote a
random variable with an invariant distribution. The dollar size of the bet is P (t ) Q (t ), and the
standard deviation of returns in one unit of business time 1/γ(t ) is σ(t )/γ1/2 (t ). Then, the
standard deviation of dollar mark-to-market gains and losses on a bet Q (t ) in business time

σ(t )
= I ∗.
d
I (t ) ≡ P (t ) Q (t ) (35)
γ1/2 (t )

is conjectured to have the same distribution across assets and time.

The second hypothesis of transaction cost invariance says that the expected dollar price
impact cost C B (Q, t ) of executing a bet Q is an invariant function C B∗ ( I ) of the equivalent dollar
risk I that the bet Q transfers in business time, as defined above:

σ(t )
C B (Q, t ) = C B∗ ( I ), I ≡ P (t ) Q . (36)
γ1/2 (t )

According to the second invariance assumption, price impact cost functions are invariant across
markets and across time, when costs are measured in dollars rather than basis points and when
order sizes are measured in terms of dollar risks they transfer rather than nominal dollar value
or shares.
From these two invariance conjectures, Kyle and Obizhaeva (2016) derive various scaling
laws for bet size, number of bets, market depth, bid-ask spread, and other variables of inter-
est, relating these variables to the products of dollar volume and returns volatilities in different
powers. Next, we will prove that both of these invariance conjectures as well as the implied by
them scaling laws hold in the equilibrium in our dynamic model.

2 Model Solution
Our model has a closed-form, algebraic solution for the endogenous parameters in terms of the
exogenous constant parameters σF , θ, η, N , c I , τ, and the endogenous randomly time-varying
state variables P (t ) and Σ(t ).
To describe the solution, it is also useful to define the moment ratio m (t ) related to the ex-
1/2
pected unsigned bet size Et [∣Q (t )∣] and the standard deviation of signed bet size ( Et [Q 2 (t )])
as
Et [∣Q (t )∣]
m (t ) = . (37)
1 /2
( Et [Q 2 (t )])
Define a constant m̄ as
m̄ ∶= Et [∣i (t )∣]. (38)

17
The assumption of normally distributed signals leads to a specific value of the parameter m̄.
Since normal distributions for signals imply normal distributions for bets, the properties of a
normal distribution imply m̄ 2 = 2/π ≈ 0.6366 (with π ≈ 3.1416), and taking a square root yields
m̄ ≈ 0.7979.4

Theorem 1 (Exact Solution to the Dynamic Model). The four endogenous variables V (t ), π̄I (t ),
m (t ), and C̄ B (t ) do not vary through time; they are the following functions of the invariant
quantities η, N , θ, m̄, and c I :

ηN cI θ
V (t ) = , π̄I (t ) = , m (t ) = m̄, C̄ B (t ) = c̄ B = cI . (39)
1−θ 1−θ 1−θ

The endogenous variables λ(t ), β(t ), γ(t ), Et [∣Q (t )∣], Et [Q 2 (t )], γ(t ), γI (t ), γU (t ), 1/L (t ),
and ρ (t ) vary randomly through time as the following functions of the state variables P (t ) and
Σ(t ) and the invariant quantities τ, c̄ B , m̄, and θ:

θ2 τ 2
λ(t ) = P (t ) Σ(t ), (40)
c̄ B

c̄ B 1
β( t ) = , (41)
θ τ 1 /2 P (t ) Σ1/2 (t )

c̄ B m̄ 1
Et [∣Q (t )∣] = , (42)
θ τ 1 /2 P (t ) Σ1/2 (t )

c̄ B2 1
Et [Q 2 (t )] = , (43)
θ2 τ P 2 (t ) Σ(t )

θ τ 1 /2 η N
γ(t ) = P (t ) Σ1/2 (t ), γI (t ) = θ γ(t ), γU (t ) = (1 − θ ) γ(t ), (44)
c̄ B m̄ (1 − θ )

1 θ τ1/2 1/2
= Σ ( t ), (45)
L (t ) m̄

θ 3 τ 3 /2 η N
σ2 (t ) = P (t ) Σ3/2 (t ). (46)
c̄ B m̄ (1 − θ )
4
Under different distributions for i (t ), Jensen’s inequality implies 0 < m̄ ≤ 1. The maximum value m̄ = 1 is
attained if and only if i (t ) is a binomial random variable with equally likely values of +1 and −1. We do not replace
m̄ with its value implied by a normal distribution, because the solution to the model does not depend on the
normality assumption except for its effect on m̄. Our results do not change if the distribution of signals i (t ) is
changed to a different distribution with mean of zero and variance of one.

18
 θ 3 τ 3 /2 η N
ρ (t ) = P (t ) Σ1/2 (t ). (47)
c̄ B m̄ (1 − θ )
Proof. See Appendix A.3.

The endogenous quantities in the model are all functions of the two state variables P (t ) and
Σ(t ), which change randomly due to arrival of bets and realization of fundamental uncertainty.
The dynamics of P (t ) and Σ(t ) can be summarized by

P (t + ∆t ) − P (t ) λ(t ) Q (t )
= = θ τ1/2 Σ1/2 (t ) i (t ), (48)
P (t ) P (t )

Σ(t + ∆t ) = Σ(t ) (1 − θ 2 τ) + σ2F Et [∆t ] . (49)

Equation (48) says that, upon arrival of a bet at time t , the price jumps by an amount pro-
portional to the new signal i (t ) with the proportionality coefficient θ τ1/2 Σ1/2 (t ), which reflects
the signal’s precision θ τ1/2 and the accuracy of the price Σ1/2 (t ) just before the signal arrives
(see equation (16)). Between arrival of bets the price stays constant.
Equation (49) says that, upon arrival of a bet based on signal i (t ) at time t , the error vari-
ance Σ(t ) drops by θ 2 τ Σ(t ), as the price incorporates the information content of the bet. Sub-
sequently, over the interval [t , t + ∆t ), the error variance increases by σ2F ∆t due to realization
of fundamental uncertainty, so that Σ(t + ∆t ) is the error variance just before the next bet ar-
rives at time t + ∆t . Note that θ 2 τ measures the fractional reduction in the error variance as
a result of the information content of a bet. If market makers could tell whether each bet was
informed or uninformed, then the error variance would decrease by fraction τ with probability
θ when an informed bet arrived and would remain unchanged with probability 1 − θ when an
uninformed bet arrived; the percentage reduction would on average be θ τ, not θ 2 τ. Since mar-
ket makers cannot distinguish informed bets from uninformed bets, the price impact of a bet is
smaller (multiplied by additional factor θ) and the proportional variance reduction is only θ 2 τ,
as shown in equation (48).
Theorem 1 assumes that σF , θ, η, N , c I , and τ are constants that do not change over time.
The theorem also assumes that the unconditional distribution of the signals i (t ) does not change
over time. If the exogenous parameters vary over time or the shape of the distribution of signals
changes over time, the solution to the model is the same, but the notation for exogenous pa-
rameters such as η will need to be changed to η(t ) to reflect its dependence on time. Allowing
the exogenous parameters to be constants suggests various empirically testable invariance hy-
potheses. Here we focus on the hypotheses that the cost of private signals c I , the moment ratio
m̄ = E [∣i (t )∣], and the information content of bets θ 2 τ are invariant.

19
 According to equation (46), returns volatility σ2 (t ) depends on P (t ) and Σ(t ), both of which
are stochastic. Thus, σ2 (t ) is stochastic even though the innovation variance of fundamentals
σ2F is constant.
Even though it is easy to observe the price P (t ), the error variance Σ(t ) is hard to estimate.
This makes it impossible to use equations (40)– (47) to generate quantitative operational pre-
dictions about financial variables. In the next section on market microstructure invariance, we
show how to make these results operational by expressing them in terms of easily observable
variables.

3 Market Microstructure Invariance Relationships

Market microstructure invariance is a useful paradigm for thinking about trading in different
markets. We show next how the ad hoc empirical conjectures and scaling laws of Kyle and
Obizhaeva (2016) can be derived endogenously in our equilibrium model.
Our discussion addresses three related questions. First, is all of the machinery of the dy-
namic model necessary to derive these invariance relationships or only part of it? We will show
that an unconditional version of the invariance hypotheses describing mean bet size and av-
erage transaction costs relies only on four simple equations, so only a subset of the dynamic
model’s structure is necessary.
Second, does the theoretical model imply a general version of the invariance hypotheses or
impose a more specific structure? We will show that the dynamic model, taken literally, implies
a specific version of the invariance hypotheses of Kyle and Obizhaeva (2016) in which bet size
has a normal distribution and market impact is linear in bet size.
Third, does the dynamic model imply additional invariance relationships other than bet
invariance and transaction cost invariance of Kyle and Obizhaeva (2016)? We will show that
the dynamic model not only implies the two conjectures of bet size invariance and transaction
cost invariance, but also implies specific invariance relationships related to pricing accuracy
and market resiliency. The principles of pricing accuracy invariance and resiliency invariance
say that pricing accuracy is the same if its reciprocal is scaled by returns volatility per unit of
business time, and market resiliency is the same if it is measured in units of business time.

A Four-Equation Meta-Model. Many invariance results can be derived directly from only four
equations representing a subset of the assumptions of our dynamic model. We call these four
structural properties a “meta-model” because these properties are likely to be shared by many
other equilibrium models as well.
First, trading volume results from bets. Since calendar-time trading volume is the sum of

20
bets of average size Et [∣Q (t )∣] shares and these bets arrive at rate γ(t ), share trading volume
per unit of calendar time V (t ) satisfies

γ(t ) Et [∣Q (t )∣] = V (t ). (50)

This volume equation assumes that market makers take the other side of each bet, so that V (t )
simultaneously measures buy volume, sell volume, market maker volume, and bet volume. It is
the same as equation (20).
Second, the dynamic model implies that returns volatility results from the linear price im-
pact of bets. Since one bet moves prices by λ(t ) Q (t ) dollars and bets arrive at rate γ(t ), the
calendar-time variance of dollar price change σ2 (t )P 2 (t ) satisfies

σ2 (t ) P 2 (t )
λ2 (t ) Et [Q 2 (t )] = . (51)
γ(t )

This volatility equation is consistent with linear price impact of bets, but equation (51) does not
itself imply linear price impact because it is an unconditional assertion about price impact, not
a conditional assertion. It is implied by equation (30).
Third, since the dynamic model implies that each bet moves prices by λ(t ) Q (t ) dollars per
share and thus incurs a price impact cost λ(t ) Q 2 (t ) dollars, the expected dollar price impact
cost of a bet C̄ B (t ) satisfies
λ(t ) Et [Q 2 (t )] = C̄ B (t ). (52)

This price impact cost equation is consistent with price impact costs being quadratic, but equa-
tion (52) itself does not imply quadratic costs because it is an unconditional assertion about the
variance of Q (t ), not a conditional assertion about its shape as a function of Q (t ). It is the same
as equation (25).
Fourth, expected unsigned bet size Et [∣Q (t )∣] and the standard deviation of signed bet size
1 /2
( Et [Q 2 (t )]) are related by a moment ratio m (t ) satisfying

Et [∣Q (t )∣]
m (t ) = . (53)
1 /2
( Et [Q 2 (t )])

This moment equation depends on the shape of the bet size distribution. It is implied by equa-
tion (37).
The four structural equations (50)–(53) define a “meta-model” in the sense that they define
structural properties shared by many models of market microstructure without filling in de-
tails which may differ across models. Our dynamic model is one such model. Since the four

21
meta-model equations reference the first and second moments of unsigned bet size but not
other moments, the meta-model has implications only for the first two moments of bet sizes.
We will show that many invariance relationships can be derived just from these four equations
presented above.

Invariance Theorem. Our main theorem establishes the link between our model and the in-
variance results of Kyle and Obizhaeva (2016). It shows that invariance assumptions and scaling
laws can be “proved” within our dynamic equilibrium model. This is the core result of our pa-
per.
To remind notations in the following theorem, τ is the precision of a signal, and θ is the
fraction of information i (t ) incorporated by an informed trade; in the baseline model with risk-
neutral traders θ = 1/2. As shown earlier, the price follows a martingale with stochastic returns
volatility σ(t ) ∶= θ τ1/2 Σ1/2 (t ) γ1/2 (t ) from equation (31), where the arrival rate of bets γ(t ) sets
the pace of business time.

Theorem 2 (Invariance in the Dynamic Model). Suppose the distribution of signals i (t ) and the
cost c I of generating a signal are invariant, with Var [i (t )] = 1. Then bet size invariance holds in
the sense that the dollar risk I (t ) transferred by a bet per unit of business time has an invariant
distribution c̄ B i (t ), where c̄ B is the invariant expected cost C̄ B (t ) of executing a bet:

P (t ) Q (t ) σ(t ) Q (t ) 2/3
I (t ) = = W (t )(m̄ c̄ B )1/3 = c̄ B i (t ), (54)
γ1/2 (t ) V (t )

Et [∣Q (t )∣]
m (t ) =
1 /2
= m̄ ∶= E {∣i (t )∣}, (55)
( Et [Q 2 (t )])
θ
C̄ B (t ) = λ(t ) Et [Q 2 (t )] = c̄ B ∶= c I . (56)
1−θ
Transaction cost invariance holds in the sense that the expected dollar cost C B (Q, t ) of executing
a bet of size Q is an invariant quadratic function of the dollar risk I this bet transfers in units of
business time:
1 2 P (t ) Q σ(t )
C B (Q, t ) ∶= I , where I≡ . (57)
c̄ B γ1/2 (t )

The number of bets γ(t ), the size of bets Q (t ), liquidity L (t ), pricing accuracy Σ−1/2 (t ), and
market resiliency ρ (t ) are related to easily observable price P (t ), share volume V (t ), volatility
σ(t ), and trading activity W (t ) ∶= P (t ) V (t ) σ(t ) by the following invariance relationships:

2/3 2 −1 2
W (t ) λ(t ) V (t ) E {∣Q (t )∣} (σ(t ) L (t )) σ2 (t ) ρ (t )
( ) = γ(t ) = ( ) =( ) = = = 2 . (58)
m̄ c̄ B σ(t ) P (t ) m̄ V (t ) m̄ 2 θ τ Σ(t ) θ τ
2

22
Proof. See Appendix A.4.

These equations directly correspond to the empirical hypotheses and scaling laws proposed
in Kyle and Obizhaeva (2016). Equation (58) also adds new empirical predictions about pric-
ing accuracy and resiliency. The pricing error Σ1/2 (t ) is proportional to σ(t )/W 1/3 (t ), and re-
siliency ρ (t ) is proportional to W 2/3 (t ).
In our model, invariance relationships come about through the following intuition. Suppose
the number of noise traders increases for some exogenous reason. In our model, for example,
this may happen when the share price and therefore market capitalization increases, keeping
the share turnover of noise traders constant. To be specific, assume that the number of noise
traders increases by a factor of 4 (e.g., in response to the price increased by the same factor). The
model shows that the number of informed traders eventually increases by a factor of 4 as well,
since their bets are now more profitable. Business time runs 4 times faster. Each bet accounts
for a 4 times smaller fraction of daily returns variance, and therefore 2 times smaller returns
volatility (the square root of 4). The market becomes more efficient, and prices deviate less
from the fundamental value. Pricing accuracy and liquidity both increase by a factor of 2, as a
result of 4 times as many informed (and noise) bets bringing more information into the market.
Since price impact falls by a factor of 2, traders execute bets twice as large as before to cover
the same costs of their private signals. Thus, overall dollar volume in the market increases by
a factor of 8. This is the “one-third, two-thirds” intuition: One-third of the increase in dollar
volume comes from changes in bet size (81/3 = 2) and two-thirds comes from changes in the
number of bets (82/3 = 4).
Equation (58) leads to invariance relationships for bet sizes and transaction costs under the
assumption that costs of executing a bet c̄ B and moment ratio m̄ are constant across stocks. As
long as information i (t ) has the same distribution, the moment ratio m̄ is constant. Our struc-
tural model also shows that c̄ B = θ c I /(1−θ ); for example, if θ = 1/2 then c̄ B = c I . This implies that
c̄ B is constant across stocks as long as the deeper structural parameters c I (and θ) are constant
across stocks. One can think about the cost of private information c I as proportional to the
average wages of finance professionals, adjusted for their productivity or effort required to gen-
erate one bet. Finance professionals optimally allocate their skills across different markets to
maximize the value of trading on the private signals that they generate. In the equilibrium, the
average costs of generating a private signal is likely to be approximately equal across markets.
This leads to invariance patterns in the data.
The structural model shows that the invariance of pricing accuracy and resiliency requires
stronger assumptions: In addition to c̄ B and m̄ being constant, the informativeness of a bet θ 2 τ,
measured as the product of signal precision τ and the squared fraction of informed traders θ 2 ,
must be constant across time (or across stocks) as well.

23
 Although the structural model is motivated by the time series properties of a single stock as
its market capitalization changes, the model applies cross-sectionally across different securities
under the assumption that the exogenously assumed cost of a private signal c I , the shape of the
distribution of signals m̄, and the informativeness of bets θ 2 τ are constant across all markets.

Invariance as a Bridge from Theory to Practice. How would one draw empirical predictions
from our dynamic model? While the solution described in section 2 reveals the importance of
the pricing accuracy state variable Σ(t ) in driving the characteristics of the market, this variable
is difficult to pin down empirically, making it difficult to test the model’s predictions in the data.
Market microstructure invariance helps to draw practical predictions by expressing them in
terms of easily observable quantities such as prices, volume, and volatility.
We can classify all variables into three categories from the perspective of how easy they are to
observe: public, private, and deep data. First, public data are publicly available or conceptually
straightforward to estimate from public data sets such as the Center for Research in Securities
Prices (CRSP) or from Trade and Quote (TAQ) data. These data include price P (t ), volume
V (t ), and shares outstanding N . Returns volatility σ(t ) belongs in the public category as well,
because it is conceptually straightforward to estimate from public data using realized or implied
volatility, even though the implementation details of calculations may be complicated.
Second, private data are either available in proprietary data sets or conceptually easy to es-
timate from such data sets. These include information about order executions and transaction
costs, even though the implementation details may be complicated due to endogeneity and sta-
tistical power issues, as discussed by Obizhaeva (2012). For example, Kyle and Obizhaeva (2016)
use portfolio transition data; Brokmann et al. (2015) and Frazzini, Israel and Moskowitz (2012)
use proprietary trading data from specific asset managers; Angel, Harris and Spatt (2015) and
others use data from Ancerno. We classify the distribution of bet size Q (t ), the value of market
depth λ(t ), and related illiquidity measures such as 1/L (t ) as private data. Using these data,
one can also calibrate values for the expected price impact cost of a bet c̄ B and the moment
ratio m̄.
Third, deep parameters can only be inferred indirectly and with great difficulty, even from
proprietary data sets and confidential data. These parameters include pricing accuracy Σ(t ),
resiliency ρ (t ), the precision of signals τ, the fraction of informed traders θ, and the cost of
private signals c I . Their estimation involves measuring how a very noisy process evolves over a
long period of time. Of course, our model here is very stylized, with a sharp distinction between
informed traders (with the same signal precision τ) and noise traders (with signal precision
of zero). In a more empirically realistic setting, different traders might have different signal
precisions and the sharp distinction between informed and noise traders is more nuanced.

24
 Invariance suggests a simple operational approach based on equation (58) for connecting
relatively easy-to-observe public quantities—such as price P (t ), volume V (t ), and volatility
σ(t ) comprising trading activity W (t ) on the left-hand side of this equation—to more difficult-
to-observe private (deep) variables on its right-hand side. Price, quantity, and volume are pub-
lic, “macroscopic” quantities in the sense that, for a specific asset at a specific time, these quan-
tities are aggregate statistics describing the interaction of all of the traders in the market, and
their values can be estimated from aggregate market data. The distribution of bet size Q (t ), bet
arrival rate γ(t ), the average cost of a bet 1/L (t ), pricing accuracy Σ1/2 (t ), and resiliency ρ (t ),
and the price impact or information content of individual bets are, by contrast, “microscopic”
quantities in the sense that they are statistics describing individual bets, and their values are
difficult to observe. Invariance helps to link together macroscopic and microscopic quantities.
The constants c̄ B , m̄, and θ 2 τ in our structural model play the role somewhat similar to the
role played by Boltzmann’s constant or Avogadro’s number in physics. Theoretical models help
to fill in detail and connect them to deep parameters of the model.
Equation (58) allows to infer the quantitative operational predictions about hard-to-observe
variables by relating them to easily observable trading activity W (t ) and its components P (t ),
V (t ), and σ(t ), whereas c̄ B , m̄, and θ 2 τ become the proportionality coefficients. These paramters
c̄ B , m̄, and θ 2 τ can be estimated empirically as the intercepts in regressions of logs of the cor-
responding variables on logs of trading activity. For example, equation (58) implies that the
number of bets γ(t ) is proportional to easily observable W 2/3 (t ) with the proportionality co-
efficient (m̄ c̄ B )−2/3 . Thus, one can generate quantitative predictions about γ(t ) if he either
knows values of the parameters m̄ and c̄ B or, alternatively, estimates the value of (m̄ c̄ B )−2/3 by
regressing ln γ(t ) on lnW 2/3 (t ) and using estimate of the intercept.

Invariance Theorem and Meta-Model. Except for the very last two equalities for pricing error
Σ(t ) and resiliency ρ (t ), all other invariance results in Theorem 2 are derived based on the four
“meta-model” equations (50)–(53). Invariance relationships therefore represent general prop-
erties, inherent to many microstructure models of speculative trading. The last two invariance
relationships relating to pricing accuracy and market resiliency require the full machinery of
the dynamic model because these variables are missing from the meta-model equations.
The structural meta-model implies a particular relationship between the invariance of bet
sizes and transaction costs hypotheses. First, the meta-model equations (51), (52), and (53)
imply a specific connection between the mean of unsigned risk transfer I (t ) and transaction
cost invariant c̄ B ,
E {∣ I (t )∣} = m̄ c̄ B , (59)

or, equivalently, that the standard deviation E {∣ I ∣}/m̄ of I is equal to c̄ B . Intuitively, this eco-

25
nomic restriction follows from the assumption that market makers break even.
Second, meta-model equations (51) and (52) lead to another restriction that connects the
second moment of the bet size invariant Et [ I 2 (t )] and the cost invariant c̄ B ,

Et [ I 2 (t )] = c̄ B2 . (60)

Since signals, and therefore bets, are normally distributed, the dynamic model implies that I ∗
is distributed N (0, c̄ B2 ) and E [∣ I ∗ ∣] = m̄ c̄ B . The distribution is invariant because c̄ B and m̄ are
assumed to be invariant constants.
These equations do not imply that the entire distribution of I (t ) is invariant, because they
do not impose a specific shape on the distribution of the size of bets Q (t ), but they are consis-
tent with invariance of the entire distribution.
The restrictions (59) and (60) impose a particular structure on the proportionality constants
in invariance relationships. It allows us to link disconnected scaling relationships, derived in
Kyle and Obizhaeva (2016), to each other and write them in a consolidated “one-line” form of
equation (58) in the invariance theorem.

4 Model Discussion
Price Dynamics in the Continuous-Time Limit. In our model, prices follow a jump process
with random jumps of size λ(t ) Q (t ) arriving at random rate γ(t ). When the arrival rate of bets
is very large and the expected time between bets ∆t is small, the price process in equation (48)
can be approximated by a diffusion.

Theorem 3 (Continuous-time Limit). When the arrival rate of bets γ(t ) is large, the price process
P (t ) can be approximated by the exponential martingale and the pricing error process Σ(t ) can
be approximated by the differential equation,

dP (t )
= σ(t ) dB P (t ), (61)
P (t )

dΣ(t ) = (σ2F − σ2 (t )) dt . (62)

where the conditional steady-state pricing error Σ∗ (t ) is

2 /3
∗ σ2F 1 m̄ c̄ B σ2F
Σ (t ) ∶= = ( ) . (63)
γ(t ) θ 2 τ θ2 τ V (t ) P (t )

26
Proof. See Appendix A.5.

When returns volatility σ(t ) is greater (smaller) than fundamental volatility σF , information
is being incorporated into prices faster (more slowly) than fundamental uncertainty is unfold-
ing, and pricing error Σ(t ) in equation (63) is shrinking (increasing) at a rate σ2F − σ2 (t ). If the
two forces are in balance, then the pricing error remains constant at a level Σ∗ (t ), which we
call a conditional steady state. The conditional steady state Σ∗ (t ) does not represent a steady
state in the usual sense; it represents the level to which Σ(t ) would converge over time if market
capitalization (proxied by the price P (t )) were not changing. Keeping σF fixed, more accurate
signals θ 2 τ and more frequent bets γ(t ) make Σ∗ (t ) smaller, i.e., market prices are more accu-
rate.
While the price process is approximately a martingale diffusion, it is not a geometric Brown-
ian motion because its innovation variance σ2 (t ) is stochastic. In the continuous-time limit, re-
turns volatility σ2 (t ) in equation (46) follows a diffusion, because P (t ) follows a diffusion. The
pricing error Σ(t ) changes more gradually; not its level, but its derivative dΣ(t )/ dt = σ2F − σ2 (t )
follows a diffusion.
Looking at financial markets from a bird eye’s view, our model presents the following pic-
ture. Changes in prices P (t ) lead to immediate changes in market capitalization and thus
changes in returns volatility σ(t ) (in equation (46)) as well as changes in the arrival rate of bets
γ(t ) (in equation (44)). The value of Σ(t ) gradually drifts towards a conditional steady-state
level of Σ∗ (t ), which it is constantly chasing, but never fully converges to since the steady-
state level is itself constantly changing with changes in P (t ). When price is high and dollar
capitalization with dollar trading volume are high, returns volatility is high, bets arrive quickly,
and Σ(t ) moves quickly towards its conditional steady state level; returns volatility remains
close to fundamental volatility; and Σ(t ) does not deviate far from its conditional steady-state
level. When prices are low and dollar trading volume is low, bets arrive slowly and Σ(t ) adjusts
slowly towards its conditional steady-state level; returns volatility may remain below funda-
mental volatility for extended periods of time.
The properties of exponential martingales imply with probability one that (1) the values of
F (t ) and P (t ) will eventually converge to zero, (2) both the bet arrival rate and returns volatility
will eventually converge to zero, and (3) pricing error Σ(t ) will eventually become unboundedly
large. This is consistent with the interpretation that almost all stocks are eventually de-listed.
As Keynes would say, in the long run, all companies are dead. The model makes realistic pre-
dictions that trading volume in any given stock eventually dies out, and at any point in time,
much of the volume in the market consists of trading in a small number of active stocks.

27
Comparison with Kyle (1985). Like our dynamic model, the continuous-time model of Kyle
(1985) is a dynamic model of trading among a risk-neutral monopolistic informed trader, noise
traders, and competitive risk-neutral market markers. There are some minor modeling differ-
ences. In contrast to our model, for example, the fundamental value in Kyle (1985) does not
change over time, and there is only one informed trader who receives a private signal at the
beginning of trading and trades on it gradually throughout the game. The two models though
share several important properties.
First, the strategies of informed traders are similar in both models. In Kyle (1985), the in-
formed trader follows a strategy dx (t ) = β(t )(v − p (t )) dt ; the intensity coefficient β(t ) is not
determined from the optimization problem of the informed trader, and any function β(t ) is
optimal as long as his strategy is smooth. In our model, the strategy of informed trader is de-
fined in equation (15) as Q (t ) = θ λ−1 (t ) Et [F (t ) − P (t ) ∣ ∆B̄ I (t )]. In the baseline case, we
obtain the value θ = 1/2, but the intensity coefficient θ λ−1 (t ) itself is left undetermined in the
optimization problem of informed traders as well.
Second, the price impact parameter λ(t ) is not identified from the market efficiency condi-
tions (21) in either model. Instead, market depth is pinned down by a condition stating that
all volatility results from trading. In Kyle (1985), price impact λ = σv /σu is the ratio of the
standard deviation of fundamental dollar volatility σv to the standard deviation of order im-
balances σu . A coefficient of one on the ratio σv /σu is obtained from the restriction Σ(T ) = 0,
which says that the error variance disappears by the end of the game T , since the informed
trader has pushed prices all the way to fundamental value. In our model, price impact λ(t ) =
(P (t )σ(t ))/(γ(t ) Et [Q 2 (t )])1/2 is obtained from a similar equation (51), where the numera-
tor P (t )σ(t ) measures dollar volatility and the denominator (γ(t ) Et [Q 2 (t )])1/2 measures the
standard deviation of order imbalances.
In both models, price processes have similar properties. In Kyle (1985), the price process
has a drift toward the fundamental value from the perspective of the informed trader, who has a
perfect knowledge of what this value is. In our model as well, the price process has a predictable
drift towards fundamental value F (t ) from the perspective of any hypothetical observer who
knows the fundamental value F (t ). Appendix A.6 shows the continuous-time approximation
for the price process

dP (t )
= ρ (t ) σF (B (t ) − B̄ (t )) dt + σ(t ) dB P∗ (t )
P (t )
(64)
P (t ) 1
= −ρ (t ) (ln ( ) − Σ(t )) dt + σ(t ) dB P∗ (t ),
F (t ) 2

for some standardized Brownian motion B P∗ (t ). The speed of convergence toward fundamen-

28
tals is related to market resiliency ρ (t ).
From the perspective of market makers in both models, the price follows a martingale diffu-
sion with returns variance σ2 (t ), since the expectation of B (t )− B̄ (t ) based on public informa-
tion is zero; we obtain equation (61). In Kyle (1985), dollar return volatility σv is constant, while
in our model return volatility σ(t ) is stochastic.

Market Efficiency, Pricing Accuracy, and Resiliency. There are two different definitions of
market efficiency. Our model helps to clarify the sharp distinction between them.
Fischer Black (1986) conceptualizes market efficiency as the accuracy with which prices es-
timate fundamental value. In our model, the pricing error Σ1/2 (t ) is directly related to this
concept of market efficiency, because it measures the standard deviation of the log-distance
between the fundamental value and the price. Black’s definition of market efficiency contrasts
with the conventional definition of market efficiency, associated with Eugene Fama.
Fama conceptualizes a market to be efficient, if all available information is appropriately
reflected in price; this implies that prices—adjusted for the risk-free rate, dividend yield, and
risk premium—follow a martingale, regardless of how much information is available overall in
the market.
In our model, prices in equation (64) are always efficient in the sense of Fama’s definition,
because prices are martingales. Yet, the pricing accuracy—Black’s measure of efficiency—varies
endogenously over time, the log-distance between prices and fundamentals may be either large
or small; higher capitalization (higher P (t ) in our model) is associated with more bets and
greater efficiency in the sense of Black’s definition.
Black conjectures that “almost all markets are efficient” in the sense that “price is within a
factor 2 of value” at least 90% of the time. Since the probability that a normal distribution is
within 1.64 standard deviations of its mean is approximately equal to 90%, his conjecture for-
mally holds in case a 1.64 standard deviation event does not deviate from the mean by more
than a factor of 2 in almost all markets. In the context of our model, Black would say that mar-
kets are efficient if Σ1/2 (t ) < ln(2)/1.64 ≈ 0.42. The market becomes more efficient if the stan-
dard deviation of the log-distance Σ1/2 (t ) between observable prices and unobservable funda-
mentals becomes smaller.
It is convenient to scale the pricing error variance Σ(t ) by annual returns variance σ2 (t ) and
think about Σ(t )/σ2 (t ) that quantifies the number of years by which the informational content
of prices lags behind fundamental value given current level of returns volatility. If prices are less
accurate and returns volatility is lower (larger Σ(t ) and smaller σ2 (t )), it will take more years
for prices to catch up with fundamentals. For example, suppose a stock’s annual volatility is
σ(t ) = 0.35 and Σ1/2 (t ) = ln(2)/1.64, as before. Then prices are about 1.50 years behind fun-

29
damental value, since Σ(t )/σ2 (t ) = (ln(2)/1.64)2 /0.352 ≈ 1.50. On average, it would take about
1.50 years of 35% annual returns volatility for prices to converge to fundamental value under
the assumption that the fundamental value remained frozen in time.
Black’s measure of market efficiency Σ−1/2 (t ) is difficult to observe directly in the data, since
fundamental value is unobservable. It is possible though to infer it indirectly from the closely
related, easier-to-observe measure of market resiliency, also discussed by Black (1986). Market
resiliency ρ (t ) is the mean-reversion parameter (per calendar year) measuring the speed with
which a random shock to prices—resulting from execution of an uninformative bet—dies out
over time, as informative bets drive prices back towards fundamental values. If resiliency is
approximately constant over a given time period, then the half-life of an uninformative shock
to prices is equal to ln(2)/ρ (t ).
Black (1986) intuited that since transitory noise affects prices, returns variance is twice as
large as innovations in fundamental value, and this implies mean reversion in returns. This in-
tuition is incorrect, because prices have a martingale property due to efficient pricing. Black’s
intuition is correct when applied to the log-ratio of prices to fundamental value, rather than
prices themselves: It is the difference between prices and fundamentals that exhibit mean-
reversion, not prices themselves. If prices become disconnected from fundamentals perma-
nently, the presence of a bubble creates arbitrage opportunities for traders without private in-
formation. In our model, trading based on private information gradually drives prices towards
fundamental value, preventing bubbles.
More formally, equations (4), (29), (30), and (34) yield the following results for market re-
siliency ρ (t ), volatility σ(t ), and pricing error Σ(t ):

Σ(t ) = Vart [σF (B (t ) − B̄ (t ))] , (65)

σ2 (t ) = θ 2 τ Σ(t ) γ(t ), (66)

σ2 (t )
ρ (t ) = θ 2 τ γ(t ) = . (67)
Σ(t )
Equation (64) illustrates the relationship among these three variables and the price process
P (t ). Market resiliency ρ (t ) is greater in markets with higher pricing accuracy Σ−1 (t ) and
higher returns volatility σ(t).
Equation (67) suggests an empirical strategy for calibration of pricing accuracy Σ(t ) from an
estimate of resiliency ρ (t ), which can be obtained by examining how fast the temporary price
impact of noise trades dies out over time.In the previous example, if a stock’s annual volatility

30
is about 35% and Σ1/2 (t ) = ln(2)/1.64, then prices are about 1.50 years behind the fundamental
value, Σ(t )/σ2 (t ) ≈ 1.50. The error B (t )− B̄ (t ) in equation (33) and prices P (t ) in equation (64)
mean-revert at rate ρ (t ) = σ2 (t ) Σ−1 (t ) = 0.352 /(ln(2)/1.64)2 = 0.69 per year. This implies that
the half-life of the price impact of noise trades is equal to ln(2)/ρ (t ) ≈ 1 year. Black (1986)
could, therefore, have equivalently defined an efficient market where “price is within a factor 2
of value” as one in which “the half-life of the price impact of noise trades is less than one year.”
The empirical strategy of using ρ (t ) to infer pricing accuracy Σ−1/2 (t ) also makes it possible
to infer the information content of a bet θ 2 τ. Equations (67) imply θ 2 τ = ρ (t )/γ(t ). To illustrate
the concept, suppose it is known that Black’s marginally efficient stock with ρ (t ) ≈ 0.69 per year
has about 20 bets per day, or 5000 bets per year based on 250 trading days per year. It immedi-
ately follows that θ 2 τ ≈ 0.69/5000 = 1.38 × 10−4 . From equation (49), the invariance of resiliency
and pricing accuracy then implies that, in any market and at any time, one bet reduces the error
variance of prices Σ(t ) by 0.0138 percent.

Liquidity. There are several ways to express liquidity L (t ) in our model. Equations (32) and (58)
imply that liquidity L (t ) is given by5

1 /3
m̄ 2 P (t ) V (t )
L (t ) = ( ) . (68)
c̄ B σ2 (t )

Note that liquidity depends on actual volatility σ2 (t ), not fundamental volatility. This equation
says that liquidity is a function of dollar volume and volatility at a particular point in time dur-
ing the trading day; it is related to how fast information is being incorporated into prices at a
particular time of day.
Equation (45) implies another expression for liquidity,

m̄
L (t ) = Σ−1/2 (t ). (69)
θ τ 1 /2

It says that liquidity is proportional to pricing accuracy Σ−1/2 (t ), which measures how much
information has been incorporated into prices from past trading. It has nothing to do with how
fast information is being incorporated into prices at a particular time of day. By imposing a
strong volume-volatility relationship on the equilibrium price discovery process, the dynamic
model makes both of the formulas for liquidity valid simultaneously.

Approximations. To obtain a close-form solution, we make several assumptions involving ap-

proximations. First, we assume that the valuation error B (t ) − B̄ (t ) is approximately normally
5
This definition is the same as in Kyle and Obizhaeva (2016) and Kyle and Obizhaeva (2017).

31
distributed. This assumption makes the filtering problem of an informed trader linear when
the signal of an informed trader is jointly normally distributed with the valuation error. This
assumption is an approximation because each price increment is a mixture—not a sum or an
average—of trades by either informed traders or noise traders.
Second, we assume that an informed trader chooses a quantity to trade which is linear in
the estimate of the information content of the private signal. This assumption makes the quan-
tity Q (t ) observed by market makers jointly normally distributed with the valuation error and
thus justifies linear filtering by market makers. This assumption is an approximation because a
linear approximation to the exponential function associated with geometric Brownian motion
is used.
Third, we assume that the market makers choose a price impact parameter λ(t ) so that
price impact is a linear function of the quantity traded Q (t ). This assumption makes price
changes approximately normally distributed and justifies linear filtering. It is an approxima-
tion because the geometric Brownian motion assumption implies that price impact should be
nonlinear.
Fourth, we assume that the continuous arrival rates of informed bets γI (t ) and noise bets
γU (t ) do not change between the arrival of one bet and the next. This assumption makes it eas-
ier to model the arrival time between bets, for example, as an analytically tractable exponential
distribution. It is an approximation because the arrival rate should theoretically increase grad-
ually between one bet arrival and the next because it is a function of the pricing error Σ1/2 (t ),
which increases continuously between bet arrivals due to unobserved innovations in funda-
mental value F (t ).
For empirically reasonable parameter values describing publicly traded stocks with reason-
ably active trading volume, we believe that all of these approximations involve economically
inconsequential errors. Proving this formally is a topic for future research, but simulations in
Appendix A.1 provide some supportive evidence.

Robustness of Assumptions. Our structural model makes restrictive assumptions that lead to
specific properties of equilibrium. Private signals are normally distributed. As linear functions
of private signals, bets are therefore also normally distributed. Price impact is linear in bet
size. Informed traders place one bet rather than shredding bets into many pieces and executing
them at an equilibrium speed over time. Market makers do not make profits; there are no bid-
ask spread costs; there are no “effective bid-ask spread” costs related to immediate reversal of
temporary price impact after execution of bets.
The empirical evidence is certainly more consistent with more general empirical hypothe-
ses about bet sizes and transaction costs, rather than the predictions of our structural “linear-

32
normal” model. For example, Kyle and Obizhaeva (2016) find that the sizes of unsigned bets
closely fit a log-normal distribution with log-variance of 2.50, not a normal distribution. Al-
though a linear price impact model predicts transaction costs reasonably well, a square root
model predicts transaction costs better. We conjecture that it may be possible to modify our
structural model to accommodate non-normally distributed bet size, non-linear price impact,
and dynamic execution of bets at an equilibrium speed proportional to the rate at which busi-
ness time unfolds, but it will make the model much less tractable.

5 Conclusion
The dynamic structural model described in this paper is to be interpreted as a “proof of con-
cept” that invariance hypotheses and scaling laws may be derived in the context of a reason-
able, well-specified theoretical model of speculative trading. At the same time, the empirical
conjectures of Kyle and Obizhaeva (2016) are likely to hold more generally than the somewhat
restrictive assumptions of our structural model.
The derivation of invariance relationships relies mostly on the four meta-model equations (50)–
(53). These equations capture generic properties of models of speculative trading: (1) order flow
creates volume and induces volatility, (2) the expected dollar transaction costs of a bet are in-
variant across assets and time, and (3) the ratio of moments of bet size distributions is stable
across assets and time. We therefore conjecture that more general invariance relationships can
be obtained in the context of other market microstructure models as well. Kyle and Obizhaeva
(2017) derive more general scaling laws based on dimensional analysis and leverage neutrality,
thus confirming this intuition.

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http://dx.doi.org/10.2139/ssrn.1178722.

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34
Treynor, Jack. 1995. “The Only Game in Town.” Financial Analysts Journal, 51(1): 81–83 (reprint
of Walter Bagehot, pseud. 1971. “The Only Game in Town.” Financial Analysts Journal, 22(2):
12–14, 22).

A Proofs

A.1 Approximation for the Distribution of Errors

As described in equation (4), our linear solution relies on the assumption that errors σF (B (t ) − B̄ (t ))
are distributed approximately as a normal distribution N (0, Σ(t )). We analyze how robust this
approximation is using numeric simulations.
We make the following assumptions about the model parameters, which closely match a
numeric example in Section 4: The annual volatility of fundamentals is σF = 0.35, the fraction
of informed traders is θ = 0.5, the unconditional dollar costs of producing a signal is c̄ B = 2000,
the moment ration is m̄ = 0.80, the number of shares outstanding is N = 250 millions of shares,
the turnover of noise traders is η = 0.5, and the annualized precision of private information is
τ = 0.000552, which is obtained as ρ (t )/(γ(t )θ 2 ) under the assumption that annual resiliency
ρ (t ) = 0.69 and there are γ(t ) = 5000 bets executed per year (20 bets per day over 250 days).
We simulate 100,000 scenarios with the arrival of 50,000 bets, which approximately corre-
sponds to a ten-year time period. As the initial starting point for each scenario at time t 0 we
assume that fundamental F (t 0 ) is $40, price P (t 0 ) is $40, error variance Σ(t 0 ) is 0.422 and the
expected number of bets γ(t 0 ) is 5000 per year.
On each kth step, we assume that a trader arrives after time ∆t = 1/γ(t k ), defined in equa-
tion (31). This trader can be either informed or noise trader, both possibilities with probabilities
τ1/2
of 1/2. If a trader is an informed trader, then he observes a signal i I (t k ) = σF (B (t k ) − B̄ (t k ))+
Σ1/2 (t k)
Z I (t ), as defined in equation (7); using equations (1) and (5), the current error σF (B (t k ) − B̄ (t k ))
can be inferred from current fundamentals and prices as ln(F (t k )/P (t k ))+ 0.5 Σ(t k ). If a trader
is a noise trader, then he observes a signal iU (t k ) = ZU (t k ), as defined in equation (17). We
The figure shows that the simulated distribution of steady-state scaled errors between prices
next update arrival rate of bets γ(t k +1 ) using equation (44), the fundamental value F (t k +1 ) us-
and fundamentals σF (B (t K +1 ) − B̄ (t K +1 ))/Σ1/2 (t K +1 ) indeed does not differ much from the
ing equation (1), the share price P (t k +1 ) and the error variance Σ(t k +1 ) using recursive equa-
standardized normal distribution. Panel A 2a shows the histogram of these simulated scaled
tions (48) and (49).
errors, and panel B 2b shows the quantile-to-quantile plot of the simulated distribution against
After 100,000 of such updates, we calculate the final distribution of errors σF (B (t K +1 ) − B̄ (t K +1 ))
the standardized normal distribution with the zero mean and unit variance. Both figures sug-
at time t K +1 as ln(F (t K +1 )/P (t K +1 ))+0.5 Σ(t K +1 ) and then scale it by Σ1/2 (t K +1 ). This simulated
gest that the normal approximation is reasonable. Even the formal Kolmogorov-Smirnov test
distribution of standardized errors is assumed to be close to a standardized normal in our solu-
produces the p-value of p = 0.51 and does not reject the normality assumption.
tion, as described in equation (4).

35
 Distribution of Errors Probability Plot
0.40 4
0.35
0.30 2

Ordered Values
0.25
0.20 0

0.15
−2
0.10
0.05 −4
0.00
−4 −2 0 2 4 −4 −2 0 2 4
Theoretical quantiles

(a) Distribution of Scaled Errors. (b) Quantile–Quantile Plot.

In our simulations, the median error variance Σ(t K +1 ) is equal to 0.0564, the median price
is $35.97, the median fundamental value is $35.22, and the median number of bets is 15,682
per year. This is consistent with the median conditional steady-state error variance Σ∗ (t K +1 ) ∶=
σ2F
γ(t K +1 ) θ 2 τ
in equation (63), which is equal to 0.0567. Since the median Σ1/2 (t K +1 ) is equal to
0.23, and it is less than ln(2)/1.64 or 0.42, the simulated market is efficient in the sense of Fischer
Black.

A.2 Proof of Equation (9) for the Updating Rule for Informed Traders
It can be shown using equation (4), the definition of ∆B̄ I in equation (8), and the law of total
variance that the difference σF (B (t )−B̄ (t )) is distributed normally, conditional on observation
of signal i I (t ), with the mean of σF ∆B̄ I (t ) and variance of Σ(t ) − σ2F Vart [∆B̄ I (t )]. Then the
update by the informed trader can be approximated by the linear function

Et [F (t ) − P (t ) ∣ ∆B̄ I (t )] = P (t ) Et [exp (σF (B (t ) − B̄ (t )) − 21 Σ(t )) − 1 ∣ ∆B̄ I (t )]

≈ P (t )( exp (σF ∆B̄ I (t ) − 12 σ2F Vart [∆B̄ I (t )]) − 1)

(A-1)
≈ P (t ) (σF ∆B̄ I (t ) − 1 2
2 σF ( Vart [∆B̄ I (t )] − ∆B̄ I2 (t ))) .
≈ P (t ) σF ∆B̄ I (t ).

36
The first line of this equation uses equations (1) and (5) for F (t ) and P (t ). The second line
of the next equation then follows from E [exp(x )] = exp( E [x ] + 12 Var [x ]) when x is normally
distributed. The second line is exact if B (t ) − B̄ (t ) is exactly jointly normally distributed with
the zero-mean signal i I (t ). The third line is a Taylor series approximation to the exponential
function which keeps second-order terms. The fourth line sets the second-order terms to zero
using the approximation Var [∆B̄ I (t )] ≈ ∆B̄ I2 (t ), which is exact in expectation.

A.3 Proof of Theorem 1

Equations (16), (23), (26), (24), and (28) yield equations (39). Equation (16), the symmetry of the
distributions of signals, and Vart [i ] = 1 imply m = Et [∣i (t )∣]. Equations (16) and (25), with
Et [∣i 2 (t )∣] = 1 due to zero means and unit variances of signals, yield equation (40). Equa-
tions (16) and (40) yield equation (41). Equations (16) and (37) yield equation (42). Equa-
tion (16), with Et [∣i 2 (t )∣] = 1 due to zero means and unit variances, yield equation (43). Equa-
tions (19) and (20), with equations (42) and (39), yield equation (44). Equations (27) and (42)
yield equation (45). Equations (29), (34), (39), and (44) yield equation (46). Equations (29), (34),
(39), and (44) yield equation (47).

A.4 Proof of Theorem 2

Equations (55) and (56) follow from equation (39). The value c̄ B = θ c I /(1 − θ ) is constant across
stocks, since c I is constant across stocks by assumption and θ is equal by proof to θ = 1/2 for
risk-neutral informed traders (or, alternatively, constant by assumption for more general cases).
Dividing both sides of the definition I (t ) ∶= P (t ) Q (t ) σ(t ) γ−1/2 (t ) by the equation C̄ B (t ) ∶=
λ(t ) E {Q 2 (t )}, plugging in the definitions of Q (t ) from equations (16), and using equation (31),
we obtain the third equality I (t ) = c̄ B i (t ) in equation (54); the first equality in equation (54) is
the definition of I (t ), and the second equality (involving W 2/3 ) will follow from equation (58)
proved below. Since i (t ) is invariant by assumption and c̄ B is invariant by proof, I (t ) = c̄ B i (t )
has an invariant distribution. Note that both I (t ) and c̄ B are measured in dollars while i (t )
represents dimensionless information.
To derive equation (57), we get λ(t ) from the equation c̄ B ∶= λ(t ) E {Q 2 (t )}, plug it into
C B (Q, t ) = λ(t ) Q 2 , then plug Q obtained from the definition I ∶= P (t ) Q σ(t ) γ−1/2 (t ), and fi-
nally use E { I 2 (t )} = c̄ B2 from I (t ) = c̄ B i (t ) in equation (54) and E {i (t )2 } = 1.
Invariance relationships in equation (58) are derived based on the four structural economic
equations (50)–(53), which define a “meta-model.” In this system of four equations, one can
think of γ(t ), λ(t ), E {Q 2 (t )}, and E {∣Q (t )∣} as unknown variables to be solved for in terms of
known variables V (t ), c̄ B , P (t ), and σ(t ).

37
 Using the definition of trading activity W (t ) = P (t ) V (t ) σ(t ), we can solve equations (52)–
(53) for γ(t ), E {∣Q (t )∣}, and λ(t ), as follows. Multiply the product of (50) and (52) by the square
root of (51) and solve for γ(t ) to obtain

−2/3
γ(t ) = (m̄ c̄ B ) W 2 / 3 ( t ). (A-2)

Divide the product of (51) and the square of (52) by (50) and solve for E {∣Q (t )∣} using (53) to
obtain
2 /3
E {∣Q (t )∣} = (m̄ c̄ B ) V (t ) W −2/3 (t ). (A-3)

Divide the product of (51) and the square root of (52) by (50) and solve for λ(t ) to obtain

1 /3
m̄ 2 1
λ(t ) = ( ) W 4/3 (t ). (A-4)
c̄ B V 2 (t )

Equation (A-3) and the definition of illiquidity 1/L (t ) ∶= c̄ B /(E {∣P (t ) Q (t )∣}) imply that 1/L (t )
satisfies
−1/3
1 m̄ 2
=( ) σ(t ) W −1/3 (t ). (A-5)
L (t ) c̄ B

To get equations for two more variables—pricing accuracy Σ−1/2 (t ) and resiliency ρ (t )—we
need to add two more equations that will define these variables to the system of the four equa-
tions. These two equations are equations (30) and (34) with Et [∆t ] = 1/γ(t ). Then, using equa-
tion (A-2) obtain
σ2 (t ) 1 2 /3 2
ρ (t ) = =( ) θ τW 2/3 (t ). (A-6)
Σ(t ) m̄ c̄ B

Equations (A-2) for γ(t ), (A-3) for Q (t ), (A-5) for 1/L (t ), and (A-6) for 1/Σ1/2 (t ) and ρ (t ) are
summarized in equation (58).
These equations directly correspond to the empirical hypotheses in Kyle and Obizhaeva
(2016). Indeed, equation (54) in Theorem 2 directly corresponds to bet size invariance. Equa-
tion (57) in Theorem 2 directly corresponds to transaction costs invariance; equation (56) is
the unconditional version of the same statement. Equation (58) summarizes empirical im-
plications about bet arrival rate, bet size, and price impact. The bet arrival rate γ(t ) is pro-
portional to W 2/3 (t ); the size of bets as a fraction of volume E {∣Q (t )/V (t )∣} is proportional
to W −2/3 (t ); and market liquidity L (t ) is proportional to W 1/3 (t )/σ(t ). Since E {∣i (t )∣} = m̄
implies E {∣ I ∣} = m̄ c̄ B from (54), one can easily check that equations (A-2) for bet arrival rate
γ(t ), (A-3) for bet size Q (t ), and (A-5) for illiquidity 1/L (t ) are exactly equivalent to invariance
equations (7), (8), and (15) in Kyle and Obizhaeva (2016). This completes the proof of the theo-
rem.

38
A.5 Proof of Theorem 3
Equation (31) implies that equation (48) can be written ∆P (t )/P (t ) = σ(t ) γ−1/2 (t ) i (t ). Since
1 /2
1/γ(t ) = E [∆t ], price changes can written ∆P (t )/P (t ) = σ(t ) E [∆t ] i (t ). Since E [i 2 (t )] = 1,
1 /2
the cumulative sums of E [∆t ] i (t ) converge to a Brownian motion, which we denote B P (t ).
This proves equation (61).
Using equation (31) for returns volatility, we show that the pricing error process Σ(t ) in
equation (49) can be approximated by the differential equation (62).
The first equality in equation (63) is obtained from equation (30) by making the substitu-
tion Et [∆t ] = 1/γ(t ) and imposing the steady-state restriction σ(t ) = σF . Using equation (58),
we then obtain the second equality in equation (63) that yields an expression for the condi-
tional steady state Σ∗ (t ) expressed in terms of exogenous variables and state variables. This
completes the proof of the theorem.

A.6 Proof of Equation (64) for Price Dynamics in the Continuous Time Limit
A random bet Q (t ) is a mixture of informed and noise bets given by

⎧
⎪ τ1/2 σF
⎪
⎪β(t ) ( Σ1/2 (t ) (B (t ) − B̄ (t )) + Z I (t )) with probability θ,
Q (t ) = ⎨ (A-7)
⎪
⎪
⎩β(t ) ZU (t )
⎪ with probability 1 − θ.

The random quantity Q (t ) depends on the noise terms Z I (t ) ∼ N(0, 1 − τ), the noise term
τ1/2 σF
ZU (t ) ∼ N(0, 1), and the informative term (B (t ) − B̄ (t )) ∼ N(0, τ). Since τ is small, this
Σ1/2 (t )
mixture can be approximated as

θ τ1/2 σF
Q ( t ) = β( t ) (B (t ) − B̄ (t )) + β(t ) Z (t ). (A-8)
Σ1/2 (t )

Here, Z (t ) ∼ N(0, 1 − θ τ) approximates the mixture of Z I (t ) and ZU (t ) with probabilities θ

τ1/2 σF
and 1 − θ, respectively; the information term θ (B (t ) − B̄ (t )) approximates the mixture
Σ1/2 (t )
τ1/2 σF
of
Σ1/2 (t )
(B (t ) − B̄ (t )) with probability θ and zero with probability 1 − θ.
The price impact of a bet is given by

∆P (t ) λ(t ) Q (t ) β(t ) λ(t ) θ τ1/2 σF β(t ) λ(t )

= = (B (t ) − B̄ (t )) + Z (t ). (A-9)
P (t ) P (t ) P (t ) 1 /
Σ (t )2 P (t )

Equations (40) and (41) imply

β(t ) λ(t )
= θ τ1/2 Σ1/2 (t ). (A-10)
P (t )

39
Equation (A-9) can therefore be written

∆P (t )
= θ 2 τ σF (B (t ) − B̄ (t )) + θ τ1/2 Σ1/2 (t ) Z (t ). (A-11)
P (t )

Plugging γ(t ) by θ 2 τ = ρ (t )/γ(t ) from equation (67) and θ τ1/2 Σ1/2 (t ) = σ(t )/γ1/2 (t ) from
equation (66) into equation (A-11) yields

∆P (t ) ρ (t ) σF σ(t )
= (B (t ) − B̄ (t )) + 1/2 Z ( t ). (A-12)
P (t ) γ(t ) γ (t )

Since E [∆t ] = 1/γ(t ), equation (A-12) can be written

∆P (t ) 1/2
= ρ (t ) σF E [∆t ] (B (t ) − B̄ (t )) + σ(t ) ( E [∆t ]) Z (t ). (A-13)
P (t )

The information content of a signal τ is small. As an approximation, Var [ Z (t )] = 1 − θ τ ≈ 1

holds. Since the random variables Z (t ) are independently distributed for signals at different
1/2
times t , the cumulative sums of ( E [∆t ]) Z (t ) converge to a standardized Brownian motion
when ∆t is small. Letting B ∗ (t )
P denote this Brownian motion with Var [B P∗ (t + h ) − B P∗ (t )] =
(1 − θ τ) h ≈ 1, the price process (A-13) can be approximated as the diffusion equation:

dP (t )
= ρ (t ) σF (B (t ) − B̄ (t )) dt + σ(t ) dB P∗ (t ). (A-14)
P (t )

The price process has stochastic returns volatility σ(t ) and drifts to eliminate the pricing error
σF (B (t ) − B̄ (t )) at rate ρ (t ). This equation coincides with equation (64).
In terms of the log-difference between price in equation (5) and fundamental value in equa-
tion (1), price process (A-14) can be written as

dP (t ) P (t ) 1
= −ρ (t ) (ln ( ) − Σ(t )) dt + σ(t ) dB P∗ (t ). (A-15)
P (t ) F (t ) 2

This is the precise sense in which price drifts towards fundamental value and ρ (t ) measures
the resiliency of market prices.
Of course, the drift in equation (A-15) is conditional on observing the fundamental value
F (t ). Since Et [B (t ) − B̄ (t )] = 0 given public information, the price process (A-15) can be also

40
written as diffusion equation (61),

dP (t )
= σ(t ) dB P (t )
P (t ) (A-16)
= σF dB̄ (t ),

where B P (t ) is a standardized Brownian motion and a martingale with respect to public infor-
mation at time t ; it is instantaneously perfectly correlated with B P∗ (t ) but has different drift. It is
also instantaneously perfectly correlated with the diffusion approximation dB̄ (t ), which itself
satisfies dB̄ 2 (t ) = σ2 (t )/σ2F . The second equality in equation (A-16) can also be obtained by
applying Ito’s Lemma to equation (5). From the perspective of a market maker, the price follows
a martingale diffusion with stochastic volatility σ(t ).

41