Floors, dealer markets and limit order markets
Abstract
In dealer markets, liquidity suppliers have entire flexibility to bargain on the price with their customers. In limit order markets, they are restricted to convex schedules: they cannot sell the first share at a higher price than the second. Floor traders simply respond to the liquidity demand conveyed by brokers by crying out one price. In floor markets risk-sharing is inefficient and spreads are large. In dealer markets, risk-sharing can be efficient, but spreads tend to be large. In limit order markets, the unique equilibrium entails efficient risk-sharing and competitive spreads. Hence there is a non-monotonic relation between the efficiency of the market and the extent to which the offers of the liquidity suppliers are restricted.