Auction and Dealer Market: More insight
Auction Market and NYSE
In auction markets, buyers enter competitive bids and sellers submit competitive offers at the same time. Commonly speaking, the price at which a stock trade represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. The auction works through the way that the highest bid will be taken, and one will pay the money for bids at the second highest price (second-price sealed bidding) or the highest price (first-price sealed bidding). By matching bids and offers are then paired together, and the orders are executed. The New York Stock Exchange (NYSE) is an example of an auction market.
Seats are traded in an auction market maintained by the Secretary of the NYSE. Current bid and ask quotes are posted in prominent locations on the floor of the exchange. No transaction costs will be charged throughout this process. The market for NYSE seats is a continuous market because transactions or quote changes can be made at any time during the day.
In practice, however, seats are thinly traded, and quotes can remain in effect for several days. The seat market is a particularly simple example of a limit order book system, a trading design that is increasingly common in financial markets.
Not all transactions take place in the auction market. Private sales or transfers between individuals within the same member institution could potentially involve consideration other than cash and for this reason need not occur at or within the quoted bid and offer prices. For this reason, we focus only on public seat transactions in cash.
Dealer Market
During the class, we discussed how dealer may make prices based on the competitive and monopolized nature of the market. However, here, I want to discuss several conditions or assumptions to make dealer a dealer.
First assumption is about the Consumer Arrival and their reservation price. Each period a dealer faces customer requests for buy (sell) quotes with a constant probability q. Let Ra and Rh denote the private customer values such that the customer buys if Ra > â and sells if Rb < b, where the requested ask and bid prices (â, b) are set one period ahead. Private customer values have a uniform distribution with density d over the interval [xt+1, xt+l + d^-1] and [xt+l — d^-1, xt+1] for the ask and the bid, respectively.
Assumption 1 characterizes the competitive situation of each dealer in the B2C market segment. More unfavorable client quotes reduce (linearly) the chance of customer acceptance.
Second assumption is about the Competitive dealer market which states that dealers have access to a fully competitive interdealer market and can (via market orders) buy inventory at the (best) ask price A and sell at the (best) bid price B.
The third assumption is about the dealer objectives and inventory restraints. A dealer chooses optimal B2C quotes (â, b) at the ask and bid side, respectively, in order to maximize the expected payoff under an inventory constraint that limits her inventory level to the three values I = 1,0, -1.
With the above three assumptions, I want to dive deeper into how alternative trading system such as crossing networks (CN) will be able to affect the trading and dealing behavior.
An alternative trading system (ATS) is a trading venue that is more loosely regulated than an exchange. ATS platforms are often used to match large buy and sell orders among its subscribers. The most widely used type of ATS in the United States are electronic communication networks (ECNs)—computerized systems that automatically match buy and sell orders for securities in the market. ATS is characterized by large buy and sell transactions and are normally loosely regulated.
Examples of Reducing Dealer’s Speed after introducing the CN
One’s intuition is to applaud the resulting combination of new technology and increased competition. However, the effects of CNs on market performance and investor welfare are subtle and complex. CN is characterized by two opposing externalities. There is the usual positive (liquidity) externality, whereby an increase in the CN’s trading volume increases its liquidity, benefiting all trades and attracting additional liquidity. This also leads to a critical-mass effect: the CN must attract sufficient trading volume, or it is unable to attract any order flow. CN is also characterized by a negative externality or “crowding” effect that results from the fact that low-liquidity-preference trades compete for execution with high-liquidity-preference trades on the same side of the market. As a result, increasing the order flow going to the CN can actually reduce overall welfare. This crowding effect becomes important once the CN becomes sufficiently liquid.
Reference:
- Hendershott, Terrence, and Haim Mendelson. “Crossing Networks and Dealer Markets: Competition and Performance.” The Journal of Finance, vol. 55, no. 5, 2000, pp. 2071–2115., https://doi.org/10.1111/0022-1082.00281.
- Dunne, Peter G., et al. “Dealer Intermediation between Markets.” Journal of the European Economic Association, vol. 13, no. 5, 2014, pp. 770–804., https://doi.org/10.1111/jeea.12118.
- Spulber, Daniel F. “Market Microstructure and Incentives to Invest.” Journal of Political Economy, vol. 110, no. 2, 2002, pp. 352–381., https://doi.org/10.1086/338749.
- Hayes, Adam. “Alternative Trading System (ATS) Definition.” Investopedia, Investopedia, 10 June 2021, https://www.investopedia.com/terms/a/alternative-trading-system.asp.