Combining quote-driven and order-driven trading systems in next-generation stock markets: an experimental investigation

Abstract

We use computer-based simulations of a stock market as a background environment for experimental tests of the integration of an order-driven trading system into a dealer/quote-driven market. Experimental subjects traded using a traditional dealer quote screen (such as Nasdaq or SEAQ), to which a limit order facility was added. Subjects' trading decisions revealed that: (1) when available, the limit order facility attracted investor orders that would have otherwise gone to dealers, and reduced trading costs; (2) the relative use of market orders and limit orders was affected by the bid-ask spread, wider spreads led subjects to substitute limit orders for market orders; (3) limit order use was reduced when the dealers were provided with an informational advantage; (4) while the introduction of a limit order facility did not have an adverse effect on dealer profit margins, dealers' activities as a percentage of total volume declined. Overall, the simulation environment provides insights into the effects of market design changes, and guidance on market structure issues, such as how best to incorporate a limit order facility into a dealer market.