The quality of price formation at market openings and closings: evidence from the Nasdaq stock market

Central counterparties (CCPs) have increasingly become a cornerstone of financial markets infrastructure. We present a model where trades are time-critical, liquidity is limited and there is limited enforcement of trades. We show a CCP novating trades implements efficient trading behaviour. It is optimal for the CCP to face default losses to achieve the efficient level of trade. To cover these losses, the CCP optimally uses margin calls, and, as the default problem becomes more severe, also requires default funds and then imposes position limits

Combining Quote-Driven and Order-Driven Trading Systems in Next-Generation Stock Markets: An Experimental Investigation

We use computer-based simulations of a stock market as a background environment for experimental tests of the integration of an order-driven trading system into a dealer/quote-driven market. Experimental subjects traded using a traditional dealer quote screen (such as Nasdaq in the U.S. or the London Stock Exchange's SEAQ), to which was added a public limit order facility. Data captured on subjects' trading decisions under different market structures revealed that: (1) When available, the limit order facility was used by the subjects, attracting some orders that would have otherwise gone to dealers, and reducing investor trading costs. (2) The relative use of market orders and limit orders was related to the bid-ask spread; wider spreads (higher cost of immediate trading) led subjects to enter fewer market orders. (3) Limit order use was reduced when the dealers were provided with an "informational advantage. " (4) While the introduction of a limit order facility did not have a substantial effect on dealer profit margins, dealers' activities as a percentage of total market volume declined. Overall, we find the simulation environment is a workable device for analyzing the effect of market design changes on trader behavior and market quality. It can provide solid guidance on market structure issues, such as how best to incorporate a limit order facility in a competing dealer market.Information Systems Working Papers Serie