When It's Not The Only Game in Town: The Effect of Bilateral Search on the Quality of a Dealer Market

We report results from experimental asset markets with liquidity traders and an insider where we allow bilateral trade to take place, in addition to public trade with dealers. In the absence of the search alternative, dealer profits are large—unlike in models with risk-neutral, competitive dealers. However, when we allow traders to participate in the search market, dealer profits are close to zero. Dealers compete more aggressively with the alternative trading avenue than with each other. There is no evidence that price discovery is less efficient when the specialists are not the only game in town.     

Capital rationing, competition, and misrepresentation in budget forecasts

In this study, we ask: how does the intensity of internal competition for resources affect the communication of private information in an organization? Although competition between different divisions or units for resources is pervasive in many organizations, much of the accounting literature examines non-competitive resource allocation and thus does not provide guidance on this point. To address this question, we conduct an experiment in which a principal allocates capital among three agents, who can each propose a single project. In the high (medium, low) competition condition, principals have sufficient funds to accept only one (only two, all three) projects. We test three competing predictions based on prior literature: (1) Agents will make maximum credible misrepresentations under both medium and high competition, in order to maximize their chance of receiving capital. (2) Agents will weigh the disutility of misrepresentation against the expected utility of receiving project funding, resulting in more misrepresentation at medium than at high levels of competition, because the probability of receiving funding is lower in high competition. (3) Misrepresentation will be highest in high competition, because agents will interpret the high-competition setting as one in which misrepresentation is most necessary to win funding and most socially appropriate. Consistent with the second prediction, misrepresentation is highest in medium competition. These results suggest that a medium level of competition is a less favorable setting for voluntary information-sharing than either uncompetitive or high competition settings, and therefore costly formal enforcement mechanisms such as post-audits are likely to be more valuable in medium-competition settings.     

Information shares in a two-tier FX market

Using several measures of information share, we examine price discovery across the inter-dealer and dealer–customer market tiers in the currencies market. In the spot market, the information share of the inter-dealer tier is higher than that of the dealer–customer one for non-financial sector trades and is lower than the dealer–customer tier for foreign investors’ sell trades. In the forward market, the dealer–customer tier generally has the greater information share at the dealer’s buy side. Our results indicate the market where customers’ trades are the most informative and demonstrate how exogenous events affect price discovery across markets and market tiers.     

Belief-free price formation

We analyze security price formation in a dynamic setting in which long-lived dealers repeatedly compete for the opportunity to trade with short-lived retail traders. We characterize equilibria in which dealers’ pricing strategies are optimal irrespective of the private information that each dealer may possess. Thus, our model’s predictions are robust to different specifications of the dealers’ information structure. These equilibria reconcile, in a unified and parsimonious framework, price dynamics that are reminiscent of well-known stylized facts: excess price volatility, price to trading flow correlation, stochastic volatility and inventory-related trading.     

The Effect of the Transparency of Order Flows in a Dealer Market with Several Securities

This paper compares two trading mechanisms in a dealer market with several securities exhibiting asymmetric information and imperfect competition. These two market structures differ in the information received by market-makers. While in the first of them when setting the price of an asset, they observe the order flows of all assets, in the second one they only observe the order flow corresponding to this asset. In order to make this comparison, we analyze several market indicators such as the informed expected traded volume, the market depth, the volatility and the informativeness of equilibrium prices, and the informed traders' ex-ante expected profits. Journal of Economic Literature Classification Numbers: G10.     

Coexistence of disposition investors and momentum traders in stock markets: experimental evidence

Prior research documents that many investors disproportionately hold on to losing stocks while selling stocks which have gained in value. This systematic behavior is labeled as the “disposition effect”. The phenomenon can be explained by prospect theory's idea that subjects value gains and losses relative to a reference point like the purchase price (PP), and that they are risk-seeking in the domain of possible losses and risk-averse when a certain gain is obtainable. Our experiments were designed to test whether individual-level disposition effects attenuate or survive in a dynamic market setting. We analyze a series of 36 stock markets with 490 subjects. The majority of our investors demonstrate a strong preference for realizing winners (paper gains) rather than losers (paper losses). We adopt different reference points and compare the behavioral patterns across three main trading mechanisms, i.e. rules of price formation. The disposition effect is greatly reduced only within high-pressure mechanisms like a dealer market (DM) when the last price (LP) is assumed as a reference point, which is a more market driven (external) benchmark. If disposition investors use the PP as a reference point, which is a more mental-accounting driven (internal) benchmark, they die hard in all market settings. Interestingly, our markets do not collapse or become illiquid by disposition investors' reluctance to trade. A main reason for this is the coexistence of two or more groups of investors, e.g. momentum traders and disposition investors.     

Does internalization diminish the impact of quote aggressiveness on dealer market share?

We analyze data provided by NASDAQ to examine how quote aggressiveness affects dealer market share and whether the practice of internalization mitigates the impact of quote aggressiveness. Our empirical results show that although internalization does not reduce the impact of price aggressiveness on dealer market share, it mitigates the impact of size aggressiveness. This result suggests that although internalization may not affect the dealer's incentive to post aggressive prices, it may reduce the incentive to post large depths. We find that aggressive quotes are more effective in raising dealer market share in stocks with a less competitive (more concentrated) market structure. Our results also show that the effective spread is wider (narrower) for stocks with a smaller price (size) elasticity of dealer market share.     

银行价格竞争、融资约束与企业研发投资——基于“中介效应”模型的实证研究

近年来我国利率市场化改革积极推进,实体经济发展积极向创新驱动转型,一个亟须研究厘清的关键问题是,银行业竞争如何驱动企业创新活动？本文关注银行价格竞争对企业创新的影响,以2013—2018年沪深两市的上市企业为样本,采用“中介效应”因果分析模型,实证检验了银行价格竞争对企业研发投资的影响,并识别出以融资约束为中介渠道的作用机制。研究发现,银行价格竞争不仅会提高银行的风险容忍度,直接增加R&D投资的信贷供给意愿,而且还会通过降低贷款价格和增加贷款可得性来缓解企业整体的融资约束,间接促进企业创新活动。这一机制在解除贷款利率管制之后以及在民营企业层面体现得更加明显。本文的研究结果对于深化金融市场化改革、改善金融服务实体经济效果以及实施经济创新驱动发展战略,具有明确的政策启示。     

Intensive margin of the Volcker rule: Price quality and welfare

We analyze the impact of dealer regulation on price quality (informativeness and volatility) and its implications for the welfare of market participants. We argue that although price informativeness, volatility, and the dealer’s profitability all deteriorate, against conventional wisdom, other market participants are better off due to the dealer’s risk-shifting motive. A static model is used to clarify the main intuition, and the robustness of the welfare results, as well as the fragility of the conventional wisdom about price quality, are discussed by incorporating dynamics and endogenizing information acquisition.     

Brokered versus dealer markets: Impact of proprietary trading with transaction fees

In this study, we consider a one-period financial market with a dealer/broker and an infinite number of investors. While the dealer who trades on his own account (with proprietary trading) simultaneously sets both the transaction fee and the asset price, the broker who brings investors' orders to the market (with no proprietary trading) sets only the transaction fee, given that the price is determined according to the market-clearing condition among investors. We analyze the impact of proprietary trading on the asset price, transaction fee, trading volume, and the welfare of investors. We find that the bid and ask prices set by the dealer who can engage in proprietary trading are more favorable to average investors. As a result, both the trading volume and the transaction fee increase, and social welfare improves.     

Intermediaries and product quality in used car markets

We present empirical evidence supporting that used cars sold by dealers have higher quality: (i) dealer transaction prices are higher than unmediated market prices, and this dealer premium increases in the age of the car as a ratio and is hump-shaped in dollar value, and (ii) used cars purchased from dealers are less likely to be resold. In a model, we show that these empirical facts can be rationalized either when dealers alleviate information asymmetry, or when dealers facilitate assortative matching. The model predictions allow us to distinguish these two theories in the data, and we find evidence for both.     

DO DEALERS INFER INFORMATION FROM ORDER FLOW?

I examine strategic behavior among dealers in the NASDAQ market and document that there is a lead quote‐setting dealer in each security and that the quotes posted by this leader are informative. Other dealers free‐ride this information by following the lead quote‐setting dealer. The lead dealer can be identified by two information signals: (1) percentage of time spent on the inside market (i.e., posting inside quotes), and (2) trade volume transacted. Dealers that free‐ride the leader's quotes quickly update their posted quotes in the same direction as the leader's quote change. My findings suggest that directing trade to the lead dealer may be more advantageous than randomly routing trade.     

Trading costs and price discovery

The price discovery roles of a set of related markets or securities have been investigated in many different settings where trading costs effect is often commingled with other trading arrangement factors. In Hong Kong, regular futures and mini futures contracts as well as their underlying spot asset are all traded on a same electronic trading platform. The trading arrangements thus provide us with a unique setting where we can isolate the impacts of transaction costs on price discovery. Using Hasbrouck’s (J Finance 50:1175–1199, 1995) information share approach, it is found that in Hong Kong, the regular futures contracts market plays a dominant role in price discovery while the mini futures and cash index markets play minor roles. The results in this paper provide an unequivocal support to the trading costs hypothesis.     

A learning market-maker in the Glosten–Milgrom model

This paper develops a model of a learning market-maker by extending the Glosten–Milgrom model of dealer markets. The market-maker tracks the changing true value of a stock in settings with informed traders (with noisy signals) and liquidity traders, and sets bid and ask prices based on its estimate of the true value. We empirically evaluate the performance of the market-maker in markets with different parameter values to demonstrate the effectiveness of the algorithm, and then use the algorithm to derive properties of price processes in simulated markets. When the true value is governed by a jump process, there is a two regime behaviour marked by significant heterogeneity of information and large spreads immediately following a price jump, which is quickly resolved by the market-maker, leading to a rapid return to homogeneity of information and small spreads. We also discuss the similarities and differences between our model and real stock market data in terms of distributional and time series properties of returns.     

Dynamic order submission strategies with competition between a dealer market and a crossing network

We analyze a dynamic microstructure model in which a dealer market (DM) and a crossing network (CN) interact for three informational settings. A key result is that coexistence of trading systems generates systematic patterns in order flow, which depend on the degree of transparency. Further, we study overall welfare, measured by the gains from trade of all agents, and compare it with the maximum overall welfare. The discrepancy between both measures is attributable to two inefficiencies. Due to these inefficiencies, introducing a CN next to a DM, as well as increasing the transparency level, not necessarily produces greater overall welfare.     

Do investors prefer round stock prices? Evidence from Israeli IPO auctions

We find round number clustering in orders submitted by investors in Israeli IPO auctions. Explanations offered for price clustering, such as dealer collusion or implicit agreement to simplify negotiations, cannot explain price clustering in this market. Therefore, this is direct evidence that investors prefer round numbers.     

Liquidity,volume and price efficiency: The impact of order vs. quote driven trading

As equity trading becomes predominantly electronic, is there still value to a traditional, intermediated dealer system? We address this question by comparing the impact of the organization of trading on volume, liquidity, and price efficiency in a quote-driven dealer market and in an order-driven limit order book. Small order price impacts are higher and large order price impacts are lower in a dealer market. Prices are more efficient in the limit order book, except when the level of informed trading is high. Volume is higher in a limit order market, making this system most attractive for trading venues.     

Trade openness and inflation: The role of real and nominal price rigidities

The paper revisits the long-standing question of the impact of trade openness on the inflation–output trade-off by accounting for the effects of product market competition on price flexibility. The study develops a New-Keynesian open-economy dynamic stochastic general equilibrium model with non-constant price elasticity of demand and Calvo price setting in which the frequency of price adjustment is endogenously determined. It demonstrates that trade openness has two opposing effects on the sensitivity of inflation to output fluctuations. On the one hand, it raises strategic complementarity in firms' pricing decisions and the degree of real price rigidities, which makes inflation less responsive to changes in real marginal cost. On the other hand, it strengthens firms' incentives to adjust their prices, thereby reducing the degree of nominal price rigidities and increasing the sensitivity of inflation to changes in marginal cost. The study explains the positive relationship between competition and the frequency of price adjustment observed in the data. It also provides new insights into the effects of global economic integration on the Phillips Curve.     

Anonymity, Adverse Selection, and the Sorting of Interdealer Trades

This article uses unique data from the London Stock Exchangeto examine how trader anonymity and market liquidity affectdealers' decisions about where to place interdealer trades.During our sample period, dealers could trade with each otherin the direct, nonanonymous public market or use one of fouranonymous brokered trading systems. Surprisingly, we find thatadverse selection is less prevalent in the anonymous brokeredmarkets. We show that this pattern can be explained by the waydealers "price" the adverse selection risk inherent in tradingwith other dealers. We also relate our findings to recent changesin dealer markets.     

Stock Market Efficiency and Economic Efficiency: Is There a Connection?

In a capitalist economy, prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most “informationally efficient” prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that stock price efficiency is not sufficient for economic efficiency by showing that the model may have another equilibrium in which prices are strong-form efficient, but investment decisions are suboptimal. We also suggest that stock market efficiency is not necessary for investment efficiency by considering a banking system that can serve as an alternative institution for the efficient allocation of investment resources.