COMPARATIVE MARKET SYSTEM ANALYSIS: LIMIT ORDER MARKET AND DEALER MARKET ⁄

Abstract

In this paper, we consider the relationship between the equilibrium spreads and the liquidity supplier's risk aversion coecient, which represents the degree of risk aversion in a limit order market and a dealer market. Thus, we analyze which market is more liquid, the limit order market system or the dealer market system. It is concluded that the spread in a limit order market is not necessarily narrower than that in a dealer market, i.e., market liquidity depends on a liquidity supplier's attitude to the risky asset. 1 Introduction Markets are divided into two types of systems. One is the dealer market, where investors buy at the dealer's ask price and sell at the dealer's bid price. The other is the limit order market, where investors buy (sell) at the limit sell (buy) price that has been previously placed. The former system is in place in the NASDAQ Stock Market and the London Stock Exchange. The latter system is evidenced by the New York Stock Exchange (NYSE) 1 , the Paris Bourse and the Tokyo Stock Exchange. It is commonly noted that the dealer market system has wider spread than the limit order market system because the dealer, who is the liquidity supplier in the dealer market, is more responsible for providing immediate execution than the limit order trader, who is the liquidity supplier in the limit order market. Thus, the supplier in the former requires larger payments, which tend to widen the spread. Though academic research has discussed which system is better, there is no definitive answer. For example, in an empirical study comparing the limit order system with the dealer market system, Huang and Stoll (1996) conclude that the execution cost in NASDAQ (a dealer system) is twice as large as that in the NYSE (a limit order system). It follows that the dealer market system causes wider spreads than the limit order market system in order to manage the market. On the other hand, Suzuki and Yasuda (2005) examined the securities that switched from the limit order market system to the dealer system and found that they reduced both relative and eective bid-ask spreads in the JASDAQ market. This market, which is for venture, combined the limit order market system with the dealer market system by March 2008. In a theoretical study of the limit order market system and the dealer market system, Handa et al. (2003) extend Foucault (1999) by incorporating the asymmetric information to observe the relationship between the spread and the proportion of buyers in the market and shows that the spread in the limit order market is wider than the spread in the dealer system over almost all values of the proportion of buyers in the market.