Strategic Market Making and Risk Sharing

Abstract

We analyze the result of allowing risk averse traders to split their orders among markets when market makers are assumed to be risk averse.

We prove that linear symmetric equilibria exist in that setting. We find that market makers' aggregate expected utility of profit may increase with the number of market markers despite the fact that the aggregate liquidity always increases with it. This implies that the cost of trading for the traders may increase with the number of market makers. The larger the market makers' risk aversion, the bigger that cost is. We also find that when the number of market makers tends to infinity, their aggregate expected utility of profit tends to zero. We offer a potential answer to the ongoing debate concerning the dealers' competitiveness. Indeed, risk aversion reduces competition between market makers as it acts as a commitment for market makers to set higher prices. This commitment is higher the higher the risk aversion.

Keywords: Risk aversion, splitting orders, strategic market making

JEL Classification: G14, D82