Specialists as Risk Managers: The Competition between Intermediated and Non-Intermediated Market
47 Pages Posted: 20 Dec 2007
Date Written: October 31, 2007
We develop a model that analyzes competition between a non-intermediated market (such as an Electronic Communications Network) and an intermediated market (such as via the market specialist's structure within the NYSE) when both markets are allowed to trade the same securities. Specialists are viewed as providers of a price risk management service, a mechanism for reducing round-trip trading costs, as well as an execution risk management service. The economic value of these three specialist services is determined by five key factors (the difference in spreads between the two financial market types, investors' holding periods, the specialist's quoted spread in relation to the asset's price, the probability of executing an order in the intermediated market, and the short-term risk-free rate). An intermediated market can therefore remain viable in the face of competition from a possibly faster, non-intermediated market as long as the specialist can generate revenue for the above services that covers his/her costs associated with asymmetric information, order processing, and inventory management. Our analysis also suggests an alternative way to compensate a specialist, with a portion of the compensation paid in the form of a fixed fee and the remainder paid as a variable charge that is adjusted dynamically to reflect current market conditions for the underlying security. Numerical illustrations quantify the magnitude of the model's predictions so that investors and policy makers can gain a deeper understanding of how the trading of high- and low-spread securities might gravitate to a particular type of market.
Keywords: market microstructure, specialists, competition, theory
JEL Classification: D1, G12, G24, G1
Suggested Citation: Suggested Citation