Compensation Schemes, Liquidity Provision, and Asset Prices: An Experimental Analysis

SAFE Working Paper No. 108

33 Pages Posted: 3 Jun 2015

See all articles by Sascha Baghestanian

Sascha Baghestanian

Goethe University; Goethe University Frankfurt - Research Center SAFE

Paul Gortner

Goethe University Frankfurt - Research Center SAFE

Baptiste Massenot

Goethe University Frankfurt - Research Center SAFE

Date Written: June 1, 2015

Abstract

In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices. Investors face a trade-off between risk and return. At the benefit of a potentially higher return, they can entrust their money to a trader. However this investment is risky, as the trader might not be trustworthy. Alternatively, they can opt for a safe but low return. We study how subjects solve this trade-off when traders are either liable for losses or not, and when their bonuses are either capped or not. Limited liability introduces a conflict of interest because it makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and decrease prices. In contrast to these predictions, we find that under limited liability investors contribute to asset price bubbles by increasing liquidity provision and that caps fail to tame bubbles. Overall, giving investors skin in the game fosters financial stability.

Keywords: compensation, liquidity, experimental asset markets, bubbles

JEL Classification: C90, C91, D03, G02, G12

Suggested Citation

Baghestanian, Sascha and Gortner, Paul and Massenot, Baptiste, Compensation Schemes, Liquidity Provision, and Asset Prices: An Experimental Analysis (June 1, 2015). SAFE Working Paper No. 108. Available at SSRN: https://ssrn.com/abstract=2613432 or http://dx.doi.org/10.2139/ssrn.2613432

Sascha Baghestanian (Contact Author)

Goethe University ( email )

Gr├╝neburgplatz 1
D-60323
Frankfurt, Hessen 60323
Germany

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Paul Gortner

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Baptiste Massenot

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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