Transparency and Liquidity: A Comparison of Auction and Dealer Markets with Informed Trading




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    • Università di Napoli and ECARE (Université Libre de Bruxelles), respectively. This article was presented at the 1991 CEPR/ESF Network in Financial Markets summer workshop in Gerzensee, the 1994 AFA Meetings and Tel-Aviv University, Nuffield College, Toulouse University, the Stockholm School of Economics, and the London Business School. We thank seminar participants and especially Patrick Bolton, Ananth Madhavan, Jean Charles Rochet, Isabelle Bajeux, and an anonymous referee for helpful comments. An earlier version of this paper was circulated under the title “Auction and dealership markets with informed trading.” The authors are grateful to Studienzentrum Gerzensee for providing a congenial research environment, and to the EC for funding travel expenses under the SPES plan. Marco Pagano acknowledges financial support from the Italian Ministry of Universities and Scientific Research (MURST) and the Italian National Research Council (CNR); Ailsa Röell's research was supported by the ESRC “Functioning of Markets Initiative,” award (no. W102251005) to the LSE Financial Markets Group.


Trading systems differ in their degree of transparency, here defined as the extent to which market makers can observe the size and direction of the current order flow. We investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants. We compare the price formation process in several stylized trading systems with different degrees of transparency: various types of auction markets and a stylized dealer market. We find that greater transparency generates lower trading costs for uninformed traders on average, although not necessarily for every size of trade.