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Liquidity Provision with Limit Orders and a Strategic Specialist

By David Brown, Bob Dammon, Stephen Smith, Chester Spatt, Lara Wolfson and Seminar Participants


This article presents a microstructure model of liquidity provision in which a specialist with market power competes against a competitive limit order book. General solutions, comparative statics and examples are provided first with uninformative orders and then when order flows are informative. The model is also used to address two optimal market design issues. The first is the effect of “tick ” size — for example, eighths versus decimal pricing — on market liquidity. Institutions trading large blocks have a larger optimal tick size than small retail investors, but both prefer a tick size strictly greater than zero. Second, a hybrid specialist/limit order market (like the NYSE) provides better liquidity to small retail and institutional trades, but a pure limit order market (like the Paris Bourse) may offer better liquidity on mid-size orders. The provision of liquidity is the raison d’être for organized financial markets. 1 Investors value liquidity because it facilitates better risk sharing and encour-I thank Praveen Kumar for many invaluable discussions and Franklin Alle

Year: 2011
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