Abstract
In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices, two outcomes that are important for financial stability. Compensation schemes can drive a wedge between how investors and traders value the asset. Limited liability makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and increase prices. In contrast to these predictions, we find that under limited liability investors increase liquidity provision and asset price bubbles are larger. Bonus caps have no clear effect on liquidity provision and they fail to tame bubbles. Overall, giving traders skin in the game fosters financial stability.
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Notes
We use Fisher’s exact test to compare all treatments pairwise. Out of the six comparisons, only the differences between ULC and LLC are significant. There are no significant differences between treatments with and without limited liability or with and without caps.
Wilcoxon signed rank tests generate the following p values: 0.06 (LLC), 0.04 (UL), 0.08 (ULC)), 0.23 (LL).
Pairwise Mann–Whitney tests cannot reject the null hypothesis of equal median IPO prices at any reasonable significance levels. The pairwise p values are as follows: LL vs LLC: 0.53, LL vs UL: 0.20, LL vs ULC: 0.40, LLC vs UL: 0.38, LLC vs ULC: 0.67, UL vs ULC: 0.91. A similar picture of no significant differences arises if we focus on posted bids, rather than equilibrium prices.
We also run another series of Mann–Whitney tests, pooling observations from the unlimited and limited liability treatments, independently of the cap. The differences in terms of RAD, RD and GAD are significant at a 5 % level. Next, we pool observations from the cap and no-cap treatments, independently of the liability structure, and run a last series of Mann–Whitney tests. The differences in bubble measures are not significant at any reasonable level. Hence, prices differ along the liability but not along the cap dimension. Finally, we observe no differences in turnover in any of the pairwise comparisons, suggesting that the treatment effects on prices are not driven by differences in the quantities traded.
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We gratefully acknowledge research support from the Research Center SAFE, funded by the State of Hessen initiative for research LOEWE.
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Baghestanian, S., Gortner, P. & Massenot, B. Compensation schemes, liquidity provision, and asset prices: an experimental analysis. Exp Econ 20, 481–505 (2017). https://doi.org/10.1007/s10683-016-9493-0
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DOI: https://doi.org/10.1007/s10683-016-9493-0