Liquidity Provision with Limit Orders and a Strategic Specialist
REVIEW OF FINANCIAL STUDIES, Vol. 10 No. 1
Posted: 9 Apr 1997
There are 2 versions of this paper
Liquidity Provision with Limit Orders and a Strategic Specialist
Abstract
This paper 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--e.g., 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 midsize orders.
JEL Classification: G14
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