Specialist Participation and Limit Orders

Abstract

We present a market microstructure model to examine specialist's strategic participation decisions in a security market where there are noise traders, limit order traders, an insider and a specialist. We argue that the specialist's participation rate depends on the depth of the limit book and its uncertainty. In particular, the specialist has incentives to trade against the market trend when the limit-book depth is low and to trade with the market trend when the depth is high. Moreover, the specialist's participation rate is positively related to the limit-book depth uncertainty and the asset price volatility, but is negative related to the average trading volume. We also discuss the specialist's participation strategies under the NYSE regulation that prohibits the specialist from trading with the market trend.

Keywords: Dealer market, asymmetric information, specialist participation, limit order book

JEL Classification: D42, D82