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

Abstract

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.