Quote Competition, Preferenced Orders, and Market Shares in Multiple Dealership Markets

Abstract

This paper investigates the relationship between the quotes made by market makers and their market shares. The link is central to the design of dealership markets, it is an important assumption in the literature, but its existence is rarely tested. Using the data from the London Stock Exchange, it is shown that quotes and trades are closely related despite the heavy presence of preferenced orders. For an average market maker, (a) the mean market share of posting the best quotes is bigger than not posting the best quotes; (b) the market share increases when changing to post the best quotes, and it decreases when leaving the best quotes; (c) the fewer market makers posting the best quotes, the bigger change in the market share when the market maker moves on or off the best quotes. The results hold in the full sample and the sub-samples grouped by the number of market makers. Regression analysis is employed to explore the determinants of average market shares. The number of market makers and the variables constructed from the duration of posting the best quotes are significantly related to the market shares, and the further discounts offered by market makers have only marginal effects. Finally, a rather surprising finding in this paper is that the preferenced orders are less in less-liquid stocks. If preferenced orders reduce the incentive of market makers to compete in quotes, as Huang and Stoll (1996) suggest, then it seems the London Stock Exchange should keep the current dealership system for its small stocks.