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Price Experimentation and Security Market Structure

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  • Chris J. Leach
  • Ananth N. Madhavan

Abstract

This paper examines the role of market makers in facilitating price discovery. We show that a specialist may experiment with prices to induce more informative order flow, thereby expediting price discovery. Market makers in a multiple dealer system, unlike a specialist system, do not have the incentives to perform such costly experiments because of free-rider problems. Consequently, the specialist system may provide open markets where competition fails, but at the cost of wider bid-ask spreads. We analyze the effect of experimentation on the bid-ask spread and provide an exploratory analysis of intraday specialist data which is consistent with our price experimentation hypothesis

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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 20-92.

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Handle: RePEc:fth:pennfi:20-92

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