Price Formation and Equilibrium Liquidity in Fragmented and Centralized Markets



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    • HEC School of Management. Paper presented at the sixth world congress of the Econometric Society and the meeting of the American Finance Association, 1990. I gratefully acknowledge the helpful comments of the editor, René Stulz, the associate editor and the referee. Many thanks also to Peter Bossaerts, Patrick Bolton, Eric Briys, Michel Crouhy, Bernard Dumas, Xavier Freixas, Anne Frémault, Joel Hasbrouck, Pierre Hillion, Tom Ho, Hayne Leland, Patrice Poncet, Bob Schwartz, Raphael Shadur, Hans Stoll, and Jean-Luc Vila for stimulating discussions. Remaining errors are mine.


This paper compares centralized and fragmented markets, such as floor and telephone markets. Risk-averse agents compete for one market order. In centralized markets, these agents are market makers or limit order traders. They are assumed to observe the quotes of their competitors. In fragmented markets they are dealers. They can only assess the positions of their competitors. We analyze differences in bidding strategies reflecting differences in market structures. The equilibrium number of dealers is shown to be increasing in the frequency of trades and the volatility of the value of the asset. The expected spread is shown to be equal in both markets, ceteris paribus. But the spread is more volatile in centralized than in fragmented markets.