Market Architecture: Limit Order Books Versus Dealership Markets

Abstract

We analyze the customer's choice with respect to a limit-order book, a dealership market, and a hybrid market structure. The customer's order is competed for and divided among risk averse market makers (limit-order providers) with heterogeneous inventories. Main conclusions of the paper are as follows: (1) a risk neutral customer prefers to trade in a limit-order market instead of in any hybrid or dealership markets; (2) a risk averse customer prefers to trade in a dealership market over a limit-order book market when the number of market makers is large and when the variation in order size is significant; and (3) for risk averse customers, the hybrid market structure, when properly structured, dominates the dealership market. Findings of the paper can be understood in terms of the tradeoff between two features of the equilibrium demand schedules: a bid reduction effect that operates differently in a limit-order book versus in a dealership market, and a zero-quantity spread that is present in the book only. Results in this paper shed new light on important issues such as why the pure dealership structure is perceived as being a poor market-place for small orders, and why the limit-order book is inefficient in handling large order size variation. They also provide a rationale for the recent move in many large equity markets toward a structure where small orders are executed against a limit-order book while large orders are executed in a dealership setting.