Specialist Markets

Abstract

Abstract A specialist market system is defined as a hybrid market structure that includes an auction component (e.g., a floor auction or a limit order book) together with one or more designated market makers (“specialists”) who trade as dealers for their own account. The designated market makers have some responsibility for the market; for example, specialists are usually obligated to continuously post quotes with reasonable depth. In return, they get a preferential treatment, be it access to order flow, information about the state of the market, discounted trading fees, or direct monetary compensation from the exchange or the listed firm. While market microstructure theory shows that the hybrid structure gives rise to complex strategic interaction between limit order traders and specialists, it also suggests that the presence of specialists is more beneficial for thinly traded stocks. Preferential treatment of specialists is required for such stocks because the potential for profitable dealing is small relative to the cost of maintaining a market presence. An interesting trend over the past two decades has been the adoption of this market structure by derivatives exchanges and stock markets around the world for the trading of less active securities. Empirical research documents improvements in market quality when these securities move from a pure limit order book structure to a hybrid specialist structure.