Combining quote-driven and order-driven trading systems in next-generation stock markets: An experimental investigation

We use computer-based simulations of a stock market as a background environment for experimental tests of the integration of an order-driven trading system into a dealer/quote-driven market. Experimental subjects traded using a traditional dealer quote screen (such as Nasdaq or SEAQ), to which a limit order facility was added. Subjects' trading decisions revealed that: (1) When available, the limit order facility attracted investor orders that would have otherwise gone to dealers, and reduced trading costs. (2) The relative use of market orders and limit orders was affected by the bid-ask spread; wider spreads led subjects to substitute limit orders for market orders. (3) Limit order use was reduced when the dealers were provided with an "informational advantage." (4) While the introduction of a limit order facility did not have an adverse effect on dealer profit margins, dealers' activities as a percentage of total volume declined. Overall, the simulation environment provides insights into the effects of market design changes, and guidance on market structure issues, such as how best to incorporate a limit order facility into a dealer market.