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