Are Designated Market Makers Necessary in Centralized Limit Order Markets?

Abstract

This paper models price formation and order placement strategies in a dynamic centralized limit order market with designated non monopolist market makers. This market design differs from the NYSE and has been adopted by several stock exchanges in Europe and North America mainly for the trading of mid caps. The model is constructed as an extension of Foucault (1999) in order to include market makers who are required to provide two-sided quotes in the book. Traders can place either a market order or a limit order and, in the latter case, they can choose the order's limit price. Comparison between a limit order market with market makers and a pure limit order market yields several testable implications. First, the clearing frequency is higher in a limit order market with designated market makers. Second, the best quotes in the limit order book with market makers are either more or less attractive than in a pure order book depending on whether the best quote has been placed by a trader or a market maker. On an ex ante basis, we find that expected best quotes in the order book can be more or less favourable in the presence of market makers depending on the asset volatility and the differences in valuation among traders. The model thus yields empirical predictions relative to the added value of non monopolist market makers across assets and/or periods. Other things equal, expected best prices in a limit order book with market makers become more attractive than in a pure limit order book when the asset volatility increases. Since asset volatility decreases with equity capitalisation, our results provide a rationale for the trading of mid caps being organized as limit order books with designated dealers. By contrast, the presence of market makers on large capitalisation stock markets could deteriorate market liquidity.