Abstract

We explore information acquisition in dealer markets when the cost of information is the same for traders and market makers (MMs). Who acquires information crucially depends on the cost. When the cost is high, only speculators become informed. This case microfounds the canonical model of Glosten and Milgrom (1985), which assumed superiorly informed traders. However, MMs start acquiring information as the cost of information falls, gradually crowding out speculators. This sheds light on a well-documented empirical regularity: dealer-driven price discovery can be more important than trader-driven price discovery. Furthermore, market liquidity is non-monotonic in the cost of information: spreads shoot up in an intermediate range of cost, where informed MMs exert monopoly power, while uninformed MMs face adverse selection both from speculators and competing MMs.

Highlights

  • Dealer markets are financial markets in which market makers (MMs) act as intermediaries between sellers and buyers

  • The distribution of information among market participants plays a central role in dealer markets, for instance regarding market liquidity

  • We show that increasing π can reduce the expected spread and increase the expected squared price error

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Summary

Introduction

Dealer markets are financial markets in which market makers (MMs) act as intermediaries between sellers and buyers (collectively referred to as traders). The distribution of information among market participants plays a central role in dealer markets, for instance regarding market liquidity. MMs supply liquidity by quoting bid and ask prices. Traders submit buy and sell (market) orders.. A MM buys low and sells high, adjusting his bid-ask spread ( spread) to (a) the adverse selection faced and (b) the competition to offer the best quotes. Suppose that the cost of acquiring information about an asset’s value is the same for all market participants, that is, for traders and MMs: who becomes informed?

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