Welfare Effects of Market Making in Continuous Double Auctions

Abstract

We investigate the effects of market making on market performance, focusing on allocative efficiency as well as gains from trade accrued by background traders. We employ empirical simulation-based methods to evaluate heuristic strategies for market makers as well as background investors in a variety of complex trading environments. Our market model incorporates private and common valuation elements, with dynamic fundamental value and asymmetric information. In this context, we compare the surplus achieved by background traders in strategic equilibrium, with and without a market maker. Our findings indicate that the presence of the market maker strongly tends to increase not only total surplus across a variety of environments, but also background-trader surplus in thin markets with impatient investors, with urgency captured by a limited trading horizon. Comparison across environments reveals factors that influence the existence and magnitude of benefits provided by the market maker function.