The ecology of an order-driven market

A securities market is order-driven if the limit orders of some public participants establish the prices at which others can trade by market order at any time when the market is open. The authors consider how, without market maker intermediation, a population of public investors separates into limit order and market order traders, and how the order-driven market achieves an ecological balance between the suppliers and the demanders of immediacy. The authors also explain why a bid-ask spread is a natural property of an order-driven market, even when the market comprises a large number of participants. A stylized environment that enables the optimal bid and ask quotes to be solved for, and the bid-ask spread to be analyzed, is considered. The authors summarize empirical evidence concerning price determination in the order-driven market, and discuss implications for market structure that are suggested by the analysis.