Abstract

http://ssrn.com/abstract=168188
 
 

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Adverse Selection in Dealers' Choice of Interdealer Trading System


Peter C. Reiss


Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Ingrid M. Werner


The Ohio State University - Fisher College of Business

June 10, 1999

Dice Center Working Paper No. 99-7

Abstract:     
London equity dealers routinely use two trading systems to trade with one another. In one, they trade directly by phone, using the best bid and ask quotes as a basis for negotiation. In the other, they submit and consume anonymous limit-orders in electronic limit-order books. In this paper, we use unique data to examine why dealers might prefer one system over another. We consider the predictions of two different theoretical models that emphazise the importance of adverse selection. Our evidence shows that direct, nonanonymous interdealer trades have subsequent price impacts several times that of the anonymous electronic trades. We interpret this as evidence that dealers typically resport to direct trade when they have information that is likely to affect future prices. Given the adverse selection of interdealer trades in the direct market, one should expect to see dealers charge more for these trades. Indeed, we do. Direct interdealer trades pay the best bid or ask, while limit order trades typically receive price improvement equal to one-third of the spread in the direct market. We conclude by asking how these differences in execution costs and subsequent price impact affect the initiating and posting dealer's profits. We find that both the poster and the initiator make significant positive profits from both types of interdealer trades.

Number of Pages in PDF File: 49

JEL Classification: G10, G20

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Date posted: May 12, 2000  

Suggested Citation

Reiss, Peter C. and Werner, Ingrid M., Adverse Selection in Dealers' Choice of Interdealer Trading System (June 10, 1999). Dice Center Working Paper No. 99-7. Available at SSRN: http://ssrn.com/abstract=168188 or http://dx.doi.org/10.2139/ssrn.168188

Contact Information

Peter C. Reiss
Stanford Graduate School of Business ( email )
Stanford, CA 94305-5015
United States
650-725 2759 (Phone)
650-725-7979 (Fax)
HOME PAGE: http://www.stanford.edu/~preiss

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Ingrid M. Werner (Contact Author)
The Ohio State University - Fisher College of Business ( email )
2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-6460 (Phone)
614-292-2418 (Fax)

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References:  31
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