This paper analyzes and contrasts the process of price formation under two alternative trading mechanisms: a continuous quote-driven system where dealers post prices before order submission and an order-driven system where traders submit their orders before prices are determined. The order-driven system can operate either as a continuous auction, providing immediate order execution, or as a periodic auction, where orders are batched for execution at a pre-determined time. Throughout, trading is modeled as a game where order quantities and beliefs are determined endogenously and agents act strategically. We show that prices in the continuous dealer system are more efficient and less variable than prices in the continuous auction system. The auction mechanism is more robust in the sense that it can operate where the dealer mechanism cannot, but the reverse is not true. The two mechanisms are equivalent only in a ‘large’ market.
We demonstrate that a periodic mechanism, by pooling orders for simultaneous execution, can overcome the problems of information asymmetry that cause failure in a continuous mechanism where trading takes place sequentially. When both mechanisms are viable, a periodic system offers greater price efficiency but requires traders to sacrifice continuity. The results provide a partial explanation for differences in market organization across assets and markets.
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