Combining Quote-Driven and Order-Driven Trading Systems in Next-Generation Stock Markets: an Experimental Investigation

Abstract

We use computer-based simulations of a stock market as a background environmentfor experimental tests of the integration of an order-driven trading systeminto a dealer/quote-driven market. Experimental subjects traded using a traditionaldealer quote screen (such as Nasdaq in the U.S. or the London StockExchange's SEAQ), to which was added a public limit order facility. Datacaptured on subjects' trading decisions under different market structures revealedthat: (1) When available, the limit order facility was used by the subjects,attracting some orders that would have otherwise gone to dealers, and reducinginvestor trading costs. (2) The relative use of market orders and limit orders wasrelated to the bid-ask spread; wider spreads (higher cost of immediate trading) ledsubjects to enter fewer market orders. (3) Limit order use was reduced when thedealers were provided with an "informational advantage. " (4) While the introductionof a limit order facility did not have a substantial effect on dealer profitmargins, dealers' activities as a percentage of total market volume declined.Overall, we find the simulation environment is a workable device for analyzingthe effect of market design changes on trader behavior and market quality. It canprovide solid guidance on market structure issues, such as how best to incorporatea limit order facility in a competing dealer market.