Skip to main content
SpringerLink
Log in

Marketmaking in the Laboratory: Does Competition Matter?

  • Published:
Experimental Economics Aims and scope Submit manuscript

Abstract

This paper is the first experimental study of the effects of competition and adverse selection on the performance of market maker (MM-) markets. Information distribution may is either symmetric or heterogeneous. MM-markets are either monopolistic (the specialist markets), or competitive (the multi MM-market). Welfare comparisons are with respect to a continuous double auction (DA-) market. Informed subjects receive an imperfect signal of the true state of the world. We find three main results. First, competition among market makers significantly reduces the bid-ask spread, and increases transaction volume. Second, competition among market makers induces competitive undercutting, yielding net trading losses for market makers as a group in most periods. Third, from the perspective of uninformed traders, a competing MM-regime is optimal, since it minimizes their expected trading losses.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Admati, A. and Pfleiderer, P. (1989). “Divide and Conquer: A Theory of Intraday and Day-of-the-week Mean Effects.” Review of Financial Studies. 2, 189–224.

    Google Scholar 

  • Amihud, Y. and Mendelson, H. (1986). “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics. 17, 223–249.

    Google Scholar 

  • Bloomfield, R. (1996). “Quotes, Prices and Estimates in a Laboratory Market.” Journal of Finance. 51, 1791–1808.

    Google Scholar 

  • Bloomfield, R. and O'Hara, M. (1999). “Market Transparency: WhoWins and Who Loses?” Review of Financial Studies. 12, 5–35.

    Google Scholar 

  • Bloomfield, R. and O'Hara, M. (2000). “Can Transparent Markets Survive?” Journal of Financial Economics. 55, 425–459.

    Google Scholar 

  • Börsenzeitung, (1995). Zur führenden Börsenorganisation in der europäischen Zeitzone werden, No. 63, March 30, 8.

  • Christie, W. and Schultz, P. (1994). “Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?” Journal of Finance. 49, 1813–1840.

    Google Scholar 

  • Christie, W., Harris, J., and Schultz, P. (1994). “Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?” Journal of Finance. 49, 1841–1860.

    Google Scholar 

  • Financial Economists Roundtable (1996). “Statement on the Structure of the NASDAQ Stock Market.” Journal of Financial Services Research. 10, 105–107.

    Google Scholar 

  • Financial Times. (1997). Derivatives: Fierce battle rages for market share (author: Samer Iskander), June 27.

  • Freihube, T., Kehr, C., and Krahnen, J.P. (1999). “Was leisten die Kursmakler: Eine empirische Untersuchung der Frankfurter Wertpapierbörse.” Kredit und Kapital. 32, 426–460.

    Google Scholar 

  • Friedman, D. (1984). “On the Efficiency of Experimental Double Auction Markets.” American Economic Review. 74, 60–72.

    Google Scholar 

  • Friedman, D. (1991). “A Simple Testable Model of Double Auction Markets.” Journal of Economic Behavior and Organization. 15, 47–70.

    Google Scholar 

  • Friedman, D. (1993). “Privileged Traders and Asset Market Efficiency: A Laboratory Study.” Journal of Financial and Quantitative Analysis. 28, 515–534.

    Google Scholar 

  • Garman, M. (1976). “Market Microstructure.” Journal of Financial Economics. 3, 257–275.

    Google Scholar 

  • Glosten, L.R. (1989). “Insider Trading, Liquidity, and the Role of the Monopolist Specialist.” Journal of Business. 62, 211–235.

    Google Scholar 

  • Glosten, L.R. and Harris, L.E. (1988). “Estimating the Components of the Bid/Ask Spread.” Journal of Financial Economics. 21, 123–142.

    Google Scholar 

  • Glosten, L.R. and Milgrom, P. (1985). “Bid, Ask, and Transaction Prices in an Specialist Market with Heterogeneously Informed Traders.” Journal of Financial Economics. 13, 71–100.

    Google Scholar 

  • Hasbrouck, J. (1988). “Trades, Quotes, Inventory, and Information.” Journal of Financial Economics. 22, 229–252.

    Google Scholar 

  • Ho, T. and Stoll, H. (1981). “Optimal Market Maker Pricing under Transactions and Return Uncertainty.” Journal of Financial Economics. 9, 47–73.

    Google Scholar 

  • Ho, T. and Macris, R.G. (1985). “Market Making and the Changing Structure of the Securities Industries.” In Y. Amihud, T.S.Y. Ho, and R.A. Schwartz (eds.), Market Making and the Changing Structure of the Securities Industry, Lexington: MA, 41–66.

  • Huang, R. and Stoll, H. (1996). “Dealer versus Auction Markets: A Paired Comparison of Execution Costs on NASDAQ and the NYSE.” Journal of Financial Economics. 41, 313–357.

    Google Scholar 

  • Krahnen, J.P. (1993). “Market Makers and Traders in an Experimental Stock Market.” Working Paper, University of Giessen.

  • Krahnen, J.P., Rieck, C., and Theissen, E. (1999). “Designing an Experimental Asset Market.” In W. Bühler, H. Hax, and R. Schmidt (eds.), Empirical Research on the German Capital Market, Heidelberg: Springer, 27–54.

    Google Scholar 

  • Krahnen, J.P. and Weber, M. (1999). “Does Information Aggregation Depend on Market Structure? Market Makers versus Double Auction.” Zeitschrift f¨ur Wirtschafts-und Sozialwissenschaften. 119, 1–21.

    Google Scholar 

  • Kyle, A. (1985). “Continuous Auctions and Insider Trading.” Econometrica. 53, 1315–1336

    Google Scholar 

  • Kyle, A.S. (1989). “Informed Speculation with Imperfect Competition.” Review of Economic Studies. 56, 317–355.

    Google Scholar 

  • Lamoureux, C.G. and Schnitzlein, C.R. (1997). “When it's not the only Game in Town.” Journal of Finance. 52, 683–712.

    Google Scholar 

  • Leach, J.C. and Madhavan, A.N. (1993). “Price Experimentation and Security Market Structure.” Review of Financial Studies. 6, 375–404.

    Google Scholar 

  • LeRoy, S.F. (1989). “Efficient Capital Markets and Martingales.” Journal of Economic Literature. 27, 1583–1621.

    Google Scholar 

  • Milgrom, P. and Stokey, N. (1982). “Information, Trade and Common Knowledge.” Journal of Economic Theory. 26, 17–27.

    Google Scholar 

  • Madhavan, A. (1992). “Trading Mechanisms in Securities Markets.” Journal of Finance. 47, 607–642.

    Google Scholar 

  • Madhavan, A. and Sofianos, G. (1994). “Auction and Market Maker Markets: An Empirical Analysis of NYSE Specialist Trading.” NYSE Working Paper #94–01.

  • O'Hara, M. (1995). Market Microstructure Theory. Cambridge, Mass.: Blackwell Publishers.

    Google Scholar 

  • Pagano, M. and Roell, A. (1996). “Transparency and Liquidity: A Comparison of Auction and Market Maker Makets with Informed Trading.” Journal of Finance. 51, 579–612.

    Google Scholar 

  • Plott, Charles R. and Sunder, S. (1982). “Efficiency of Experimental Security Markets with Insider Information: An Application of Rational-Expectations Models.” Journal of Political Economy. 90(4), 663–698.

    Google Scholar 

  • Plott, Charles R. and Sunder, S. (1988). “Rational Expectations and the Aggregation of Diverse Information in Laboratory Security Markets.” Econometrica. 56, 1085–1118.

    Google Scholar 

  • Plott, C.R. and Gray, P. (1990). “The Multiple Unit Double Auction.” Journal of Economic Behavior and Organization. 13, 245–258.

    Google Scholar 

  • Seppi, D.J. (1997). “Liquidity Provision with Limit Orders and a Strategic Specialist.” Review of Financial Studies. 10, 103–150.

    Google Scholar 

  • Spulber, D.F. (1996). “Marketmicrostructure and Intermediation.” Journal of Economic Perspectives. 10(3), 135–152.

    Google Scholar 

  • Theissen, E. (1996). “Market Structure and the Aggregation of Information: An Experimental Investigation.” Working paper, University of Frankfurt.

  • Wahal, S. (1997). “Entry, Exit, Market Makers, and the Bid-Ask-Spread.” Review of Financial Studies. 10, 871–901.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Finance Department, Goethe Universitaet Frankfurt, Germany

    Jan Pieter Krahnen

  2. CFS Center for Financial Studies, CEPR, Germany

    Jan Pieter Krahnen

  3. Lehrstúhl Bankbetiiebs Lehre, Universitaet Mannheim, Germany)

    Martin Weber

Authors
  1. Jan Pieter Krahnen
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Martin Weber
    View author publications

    You can also search for this author in PubMed Google Scholar

Rights and permissions

Reprints and permissions

About this article

Cite this article

Krahnen, J.P., Weber, M. Marketmaking in the Laboratory: Does Competition Matter?. Experimental Economics 4, 55–85 (2001). https://doi.org/10.1023/A:1011493421952

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1023/A:1011493421952

Search

Navigation