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Preferencing, internalization and inventory position

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Abstract

We present a model of market-making in which dealers differ by their current inventory positions and by their preferencing agreements. Under preferencing, dealers receive captive orders that they guarantee to execute at the best price. We show that preferencing raises the inventory holding costs of preferenced dealers. In turn, competitors post less aggressive quotes. Since price-competition is softened, expected spreads widen. The entry of unpreferenced dealers, or the ability to route preferenced orders to best-quoting dealers, as internalization does restore price competitiveness. We also show that a greater transparency may negatively affect expected spreads, depending on the scale of preferencing.

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  • Lescourret, Laurence & Robert, Christian Y., 2006. "Preferencing, internalization and inventory position," ESSEC Working Papers DR 06017, ESSEC Research Center, ESSEC Business School.
  • Handle: RePEc:ebg:essewp:dr-06017
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    More about this item

    Keywords

    Internalization; Inventory Control; Market Microstructure; Preferencing; Transparency;

    JEL classification:

    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • L21 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Business Objectives of the Firm

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