Dealership Market Research Articles

Dealership versus continuous auction: Evidence from the JASDAQ market

The Japan Association of Securities Dealers Automated Quotation (JASDAQ) market for emerging firms employed two trading methods during the 1998 to 2008 period: a quote-driven dealership system and an order-driven continuous auction system. Using the unique setting in which listed firms were able to choose their preferred trading method, we evaluate which of these trading methods is more desirable in improving liquidity and price efficiency. A difference-in-differences (DID) test with matched samples indicates that the dealership system provides better trading opportunities than the continuous auction system while the transaction costs are about the same. The dealership market is superior in price efficiency, but associated adverse selection costs are high. As a result, market makers have less incentive to provide liquidity because they cannot make enough profits when trading volume is low. These findings explain why the dealership market was phased out from the JASDAQ market after March 2008.

Competing with Inventory in Dealership Markets

Existing literature on dealer liquidity provision and inventory management has focused on dealer inventory cost. I uncover a new inventory benefit channel: dealers strategically build inventory in order to compete for market share. The inventory benefit reduces the effective cost of dealer inventory holding, thereby lowering the price of liquidity provision. Using the TRACE data for the U.S. corporate bonds, I show that, excluding the 2008 crisis, the inventory benefit per trade is on average 8.4 basis points larger than the inventory cost. The result is reversed during the crisis, when dealers suffer significantly higher inventory cost.

Corporate Bond Dealers' Inventory Risk and FOMC

Macroeconomic announcements increase trading activity, with potential consequences for liquidity. This paper studies the effect of FOMC announcements on the US corporate bond market liquidity. The releases do not seem to create adverse selection. We obtain the probability distribution of monetary policy outcomes from 30 day Fed funds Futures. Despite the low toxicity of the order flow, dealers increase the price for liquidity provision in the presence of monetary policy uncertainty and unexpected Fed rate changes. Trading costs decomposition reveals that inventory risk aversion drives the dealers' behaviour. We conclude that a dealership market falls short around macroeconomic announcements, even when adverse selection may be absent.

Market quality of dealer versus hybrid markets for illiquid securities: new evidence from the FTSE AIM Index

This paper explores liquidity effects following the introduction of electronic limit-order trading for 48 illiquid stocks listed on the FTSE AIM Index. We find evidence of a sustained increase in the liquidity of the stocks as a result of limit-order trading. Furthermore, the enhancement in the liquidity of the stocks is due to a decrease in the direct cost of trading as opposed to a reduction in the asymmetric information cost of transacting. The empirical findings suggest that a hybrid market with a limit-order book and voluntary dealers outperforms a dealership market with obligatory market makers for illiquid stocks.

Simulation Research on Artificial Financial Market Based on Multiple Competitive Market-Makers

Most of the past studies about dealership market involved only one monoplistic market-maker. The paper aims to build an artificial financial market based on multiple competitive market makers on ANYLOGIC platform, in which one market-maker adopts BAYES learning rule to estimate the fundamental value and the other employs a rough method. In order to validate the effectiveness of dealers’ quotes, we carried out two group simulation experiment. The results show that the quote of each dealer can converge to the fundamental value with certain deviation. What’s more, the deviation of the market-maker with learning ability is smaller while the converging speed slower.

Semi-transparency, dealership market, and foreign exchange market quality

This paper examines the effects of a semi-transparency event, the introduction of the electronic trading system (EBS), on the market quality of a typical dealership market – the FX market. We find that increasing transparency leads to smaller quote disagreement among dealers and higher trading volume, but the beneficial effects are bigger for uninformed dealers than informed dealers. We also find that information efficiency improves overall in the semi-transparent system; however, informed dealers are found to quote less aggressively in the more transparent market. We conclude that semi-transparency raises market quality in general, but that it is the uninformed dealers who benefit more from this increased quality.

Information Content in Small and Large Trades

We estimate the probabilities of informed trading (PIN) for small and large trades and then investigate their determinants. We model a competitive dealership market for equities with two order sizes using a Poisson process mixture model and use TORQ data to estimate the parameters for the model via the method of maximum likelihood. The PIN for small and large trades are functions of the resulting parameter estimates. In our empirical tests, we find that although for the majority of securities information contents in small and large trades are similar, the average PIN for small trades is significantly higher than that in large trades. We also find that trading volume and institutional trading are the primary determinants of information content in small and large trades, respectively, but not of both. A further investigation of the securities with the largest differences in terms of PINs for small and large trades reveals that trade size alone distinguishes those firms from the rest – all eight firms reside in the lowest quartile in terms of average trade size.

Semi-Transparency, Dealership Market and Foreign Exchange Market Quality

This paper examines the effects of a semi-transparency event, introduction of the electronic trading system (EBS), on the market quality of a typical dealership market - the FX market. We find that increasing transparency leads to lower market volatility and higher trading volume, but the beneficial effects are bigger for uninformed dealers than informed dealers. We also find that information efficiency improves overall in the semitransparent system, however, informed dealers are found to quote less aggressively in the more transparent market. We conclude that semi-transparency raises market quality in general, but that it is the uninformed dealers who benefit more from this increased quality.

Some effects of transaction taxes under different microstructures

We show that the effectiveness of transaction taxes depends on the market microstructure. Within our model, heterogeneous traders use a blend of technical and fundamental trading strategies to determine their orders. In addition, they may become inactive if the profitability of trading decreases. We find that in a continuous double auction market the imposition of a transaction tax is not likely to stabilize financial markets since a reduction in market liquidity amplifies the average price impact of a given order. In a dealership market, however, abundant liquidity is provided by specialists, and thus a transaction tax may reduce volatility by crowding out speculative orders.

Strategic Experimentation in a Dealership Market

We study the strategies of the market in the inter-dealer market. We show that market makers actively learn from the dealers they trade with and strategically react to the information content of the orders they receive. We identify hiding and experimenting as main types of market makers' strategies. We show how market makers in order to assess the informational content of the orders they receive. We provide empirical evidence of this, using a unique high-frequency dataset on the Italian Treasury Bond market disaggregated at dealer level.

Information Processing in Decentralized Multiple Dealership Markets

This paper analyzes the short run dynamics and relationship between the customer dealer and the interdealer market. The sample covers euro government bonds issued by members of the EMU (European Monetary Union). During the observation period, all bonds were traded on EuroMTS, an electronic interdealer system for euro benchmark government bonds. The focus of the study is to reveal each market's contribution to the price discovery process of these bonds. The empirical results provide evidence that the customer dealer market dominates the price discovery process for euro benchmark government bonds. However, the contribution of the interdealer market to the price discovery depends on bond characteristics. The share in the price discovery process of the interdealer market is larger for less liquid bonds than for liquid bonds.

The Market Quality of Dealer versus Hybrid Markets: The Case of Moderately Liquid Securities

Abstract: Over the last decade, electronic limit‐order trading systems have been sweeping securities exchanges around the world. This paper studies a transitional case, namely, the commencement of trading of a group of moderately liquid stocks on SETS of the London Stock Exchange. The evidence reveals that the liquidity of those stocks dropped substantially after the introduction of the limit order book and the removal of the market makers' obligations. This transition provides an example that a hybrid market with a limit order book and voluntary dealers may not perform as well as a dealership market with obligatory market makers.

A comparison of different trading protocols in an agent-based market

We compare price dynamics of different market protocols (batch auction, continuous double auction and dealership) in an agent-based artificial exchange. In order to distinguish the effects of market architectures alone, we use a controlled environment where allocative and informational issues are neglected and agents do not optimize or learn. Hence, we rule out the possibility that the behavior of traders drives the price dynamics. Aiming to compare price stability and execution quality in broad sense, we analyze standard deviation, excess kurtosis, tail exponent of returns, volume, perceived gain by traders and bid-ask spread. Overall, a dealership market appears to be the best candidate, generating low volume and volatility, virtually no excess kurtosis and high perceived gain.

Price Improvement in Dealership Markets

Price improvement refers to the practice whereby dealers offer executions that improve on quoted prices. Why are these improvements given? Standard thinking is that competition causes dealers to give better prices to customers with less information. This paper contrasts this with a novel theory in which customers negotiate improvements and differential pricing arises from differences in customers' market power. Each theory affects the formation of bid/ask spreads in empirically distinguishable ways. Understanding price improvement and its impact on market participants is critical the regulation of markets, particularly since equal execution is such an important stated goal of the SEC.

The Market Quality of Moderately Liquid Securities in a Hybrid Market: The Evidence

Electronic limit-order trading systems have been sweeping securities exchanges around the world since the last decade. This paper studies a case of transition, namely, a group of moderately liquid stocks that started trading on SETS of the London Stock Exchange. The evidence reveals that the liquidity of those stocks substantially dropped after the introduction of the limit order book despite the presence of a dealer network. The transition provides an intriguing example that a hybrid market where a limit order book and dealers co-exist may not perform as well as a dealership market.

Auction Versus Dealership Markets

This paper compares two market structures, namely auction and dealership markets defined respectively as centralized order-driven and fragmented quote-driven markets. Our approach departs from previous works comparing these market mechanisms by considering both the timing of order submission (quote versus order-driven) and trading concentration (centralized versus fragmented) as dimensions differentiating these trading structures. We compare markets using measures of market viability, informational efficiency, price variance, informed trading aggressiveness and market liquidity. We find that this approach changes dramatically the results of previous works comparing these trading structures. Indeed, we prove that auction markets are less sensitive to asymmetric information problem and they exhibit higher level or informational efficiency than dealership markets. Moreovre, we find that the relative magnitude of price variance, informed trading aggressiveness and market depth in both structures depend on the market thickness.

A Theoretical Analysis of Institutional Investors’ Trading Costs in Auction and Dealer Markets

This paper compares trading costs for institutional investors subject to liquidity shocks, in auction and dealer markets. The batch auction restricts the institutions’ ability to exploit informational advantages because of competition between institutions when they simultaneously submit orders. This competition lowers aggregate trading costs. In the dealership market, competition between traders is absent but private information is revealed by observing the flow of successive orders and so reduces aggregate trading costs. We analyse the relative effects on trading costs of competition and information revelation in the two systems and derive a parameter inequality which determines which system has lower costs.

Market Making with Costly Monitoring: An Analysis of the SOES Controversy

We develop a model of price formation in a dealership market where monitoring of the information flow requires costly effort. The result is imperfect monitoring, which creates profit opportunities for speculators who pick off stale quotes. Externalities associated with monitoring give rise to multiple equilibria in which dealers earn strictly positive expected profits. We obtain various policy implications. A switch to automatic execution can improve or worsen spreads and price discovery depending on the specific equilibrium. A reduction in the minimum quoted depth tightens the spread but it reduces price efficiency. Our analysis is relevant for the SOES controversy given that speculators in our model behave as the real world SOES bandits. Our model predicts that SOES bandits should trade in stocks with small spreads and that SOES bandit activity should widen the spread. We provide empirical evidence consistent with these predictions.

Do Inventories Matter In Dealership Markets? Evidence From the London Stock Exchange

Using London Stock Exchange data, we test the central implication of the canonical model of Ho and Stoll (1983) that relative inventory differences determine dealer behavior. We find that relative inventories explain which dealers obtain large trades and show that movements between best ask, best bid and straddle are highly correlated with both standardized and relative inventory changes. We show that the mean reversion in inventories is highly nonlinear and increasing in inventory levels. We show that a key determinant of variations in inter-dealer trading is inventories and that inter-dealer trading plays an important role in managing large inventory positions.

Reputation-Based Pricing and Price Improvements in Dealership Markets

In many security markets, dealers trade with their regular clients at a discount relative to prevailing bid and ask quotes. In this article we provide an explanation to this phenomenon. We consider a dealer and an investor engaged in a long-term relationship. The dealer assigns a reputational index to his client. This index increases (reputation decreases) when the client conducts trades which results in a loss for the regular dealer. The dealer grants a price improvement if and only if the client's index is smaller than a threshold and suspends price improvements otherwise. We show that this pricing strategy induces the investor to refrain from exploiting private information against their regular dealer. We also find that it worsens the quotes posted by other dealers. For this reason, there are cases in which the investor is better off if long-term relationships are impossible (for instance, if trading is anonymous). Our model predicts that a dealer's decision to grant a price improvement depends on their past trading profits with the trader requesting the improvement.