Liquidity Provision with Limit Orders and a Strategic Specialist

REVIEW OF FINANCIAL STUDIES, Vol. 10 No. 1

Posted: 9 Apr 1997

See all articles by Duane J. Seppi

Duane J. Seppi

Carnegie Mellon University - David A. Tepper School of Business

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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

Suggested Citation

Seppi, Duane J., Liquidity Provision with Limit Orders and a Strategic Specialist. REVIEW OF FINANCIAL STUDIES, Vol. 10 No. 1, Available at SSRN: https://ssrn.com/abstract=8262

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