El Proceso de la Toma de decisiones

As I explained in previous sections, the key functions of the market makers are price discovery, liquidity and continuity, and price stabilization. The question and the basis of this comparison is whether a pure auction market can achieve the same outcomes as dealer markets but at a lower cost.

Auction and dealership markets have many significant differences. In auction markets traders send buy and sell orders to a centralized mechanism and they are cleared at a single price, whereas in dealership markets orders are placed with individual dealers, who execute them at preset quoted prices. In an auction system, unlike the dealership system, there is no difference between the buying and the selling price. Therefore, there is no noise in stock returns from the existence of the bid-ask spread. In contrast to the dealership market, in an auction market new information is more slowly reflected in prices; therefore, there might be an error in determining the price since prices may not reflect all

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available information. One main disadvantage of a pure auction system is that once a market participant provides a limit order, he “locks” at that price, being exposed against possible exogenous shock that could cause changes in values. The market participant then would “offer” a free option to the market that can be hit. Therefore, the limit order trader needs to use more resources to protect himself from this possibility, something that could result in high costs. This may be why dealers arise in auction markets. Pagano and Roell (1992) provide an appropriate basis for the understanding of the main differences between auction and dealership markets. Their paper focuses on three functional differences between the trading systems: the speed of dissemination of order flow information, the degree to which traders’ identities are known before trade, and the extent of public limit order exposure

Speed of dissemination of order flow information

The order flow provides market participants information in order to form their estimates of the true price. The more trading information available at the time the price is formed, the more of this information is included in the price. In dealership markets the publication of trading information is not immediate, therefore the market maker forms the transaction price without knowing his competitors’ recent order flow. In contrast, in auction type markets trading information is published immediately. This difference in the speed of dissemination of order flow information creates differences in the trading cost and execution risk for the two different trading systems. Under this perspective in dealership markets the trading cost will be higher than in the auction market since the market maker has less information about the recent trading history. Moreover, in dealership markets the execution risk is lower than in the auction market since the market maker provides the role of immediacy. Actually the execution risk in a dealership market is zero.

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Of course when considering the above, the two main types of investors must be also considered. For liquidity traders the auction market on average is cheaper than the dealership market when the trading cost is considered. For an informed trader the dealership market on average is cheaper, since prices do not include much of the history of the order flow.

The degree to which traders’ identities are known before trade

In an electronic auction system the identities of the market participants are not disclosed. On the other hand, in dealership markets the market maker has the ability to identify at least some traders as liquidity or informed traders. This implies that on average the transaction cost for a liquidity trader will be lower when participating in a dealership market.

The extent of public limit order exposure

The main difference between these two market organizations is identified in execution risk. When referring to execution risk we mean the possibility of not finding a counterparty to trade. Even if there are a few to trade execution risk still exists by taking the form of the uncertainty on the actual price at which the order will execute. However, when referring to execution risk we mainly mean the uncertainty of the actual execution of the order.

In dealership markets execution risk is not present since dealers have the obligation to quote firm prices publicly. Therefore, at any given time during the market operation there is someone willing to buy or sell against an incoming order at a specific bid and ask price. This means that execution risk in both forms (order execution uncertainty and price execution uncertainty) is not present. In an auction market, in contrast, execution risk is present. A trader can place a market order or a limit order as we have explained in the previous sections. By placing a market order, the order execution uncertainty is not so relevant (but still exists)

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but execution price uncertainty is very high since the order may be executed in a price much lower (sell order) or much higher (buy order) than the desired one. In order to avoid this risk the trader can place a limit order specifying the minimum or maximum price at which he is willing to trade, but then he immediately faces the risk the trade not being executed at all.

It is obvious from the above that the key issue is whether dealership markets offer higher liquidity from auction markets, where liquidity refers to price stabilization and continuity of trades. Of course this liquidity by the market makers is offered at a price (the bid-ask spread), a cost that is absent from auction markets. Therefore, it is important to examine whether it is meaningful for the traders to pay that price or to trade in an auction market and bear this risk themselves.

Another difference is that auction markets are more transparent than dealer markets, in the sense that more information can be made directly available to all market participants. They provide greater pre-trade transparency. More specifically, they provide greater visibility of the best price at which any incoming order can be executed. In electronic auction markets, brokers can scan the limit order book and see exactly at what price an order would execute. In contrast, dealer markets display very limited information, namely the ‘’firm quotes’’ at which market makers must deal for up to the posted size. Post-trade transparency, such as real-time trade publication, is not feasible in dealer markets as a deal takes a few minutes to be reported to the exchange and for the latter to publish it on screen. On the other hand, in electronic auction markets trades are subject to publication on time.

In the following section I review some of the main studies that deal with the comparison of auction and dealership markets under both a theoretical and empirical perspective. The comparison between these two market types includes the comparison of trading costs (measured by the bid-ask spread), the

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customer’s choice according to the risk-type of the customer (e.g. risk neutral), the price formation at the opening of a trade market, the informed and uniformed traders preference, the degree of transparency, information efficiency, market depth, and market thickness.