Royal Economic Society

AUCTION VERSUS DEALER MARKETS: WHICH DELIVER THE LOWEST TRADING COSTS FOR INSTITUTIONAL INVESTORS?

What is the ideal share-trading platform for institutional investors? According to research by Dr Andy Snell and Professor Ian Tonks, published in the July 2003 issue of the Economic Journal, it depends on whether share price movements are mainly influenced by ‘inside information’ or by liquidity trading by large institutional investors. In the former case, the value of a sequential dealer market in revealing information and so reducing trading costs is high. In the latter case, the value of competitive bidding in an auction system has a bigger impact in reducing trading costs.

The study examines the properties of two alternative ‘market microstructure’ systems for trading shares: a sequential dealer market and a batch auction. The research was motivated by recent changes in the way that equities are traded in London. In October 1997, following demands from the Securities and Investments Board (in turn due to lobbying from the institutional users of the trading systems), the London Stock Exchange changed its trading system in the most liquid securities from a dealership system (SEAQ) to an auction system of limit orders (SETS).

London is not alone in changing its trading system. The last few years have witnessed dramatic upheavals in the ways that European exchanges are organised. In 1997, the Deutsche Bourse adopted the Xetra electronic order book system. In 2001, the Amsterdam, Brussels, Lisbon, LIFFE and Paris stock exchanges merged to form Euronext, a pan-European exchange, using a single order-driven trading platform based on the French NSC electronic order book system. And NASDAQ, the US technology stock exchange, set up a pan-European technology exchange in 2002 based on the SuperMontage trading platform, a fully integrated central limit order book and quote-driven montage facility and execution system.

Stock exchanges are increasingly dominated by large institutional investors who are the major players in stock market turnover. A characteristic feature of these institutions is that they tend to hold large equity stakes in firms and as a result, may in certain cases have superior information about a firm's worth than the market as a whole. If the institutions are also subject to periodic liquidity requirements, they may be forced to liquidate some or all of their stakes at short notice.

In such cases, their superior information is a curse in that the prices they are offered in any market reflects a suspicion that they are selling for informational reasons rather than to satisfy cash requirements. The possibility that they have superior information therefore generates liquidity costs and it is the relative liquidity costs of institutional investors under the two trading platforms that is the focus of this research.

The study examines a sequential dealer market where institutional investors trade consecutively with competitive marketmakers and a batch auction where the institutions trade simultaneously without colluding with one another. The researchers assume that the institutions have private information about the fundamental values of the underlying securities in which they are trading, but they are also subject to liquidity shocks.

The main contribution of the research is to identify the conditions under which one trading platform is preferred to another in terms of providing lower trading costs to institutional investors. On the one hand, the batch auction restricts the institutions’ ability to exploit informational advantages because of competition between institutions, (which is absent in the dealership system) and this effect serves to reduce aggregate trading costs – a plus point for the batch auction.

On the other hand, the dealership market is able to reveal private information to the market via the flow of successive orders (a possibility that is absent in the batch auction) and this effect reduces aggregate trading costs – a plus point for the dealership.

The fact that both system have their merits in reducing trading costs leads to the result that neither trading system dominates the other by this yardstick. The structure that yields the lowest trading costs to the traders depends on parameter values that govern the relative importance of liquidity shocks to information shocks.

When asymmetric information is prevalent, the dealer markets yield lower costs because the size of the information revelation effect is more sensitive to the degree of inside information than is the competition effect.

In other words, in markets where inside information has a relatively large influence on stock price movements, the value of sequential trading in revealing information to the market and so reducing institutions' trading costs is high.

In markets where liquidity trading is the predominant source of stock price volatility, then the value of competitive bidding in reducing financial institutions' trading costs is bigger – in which case the auction market is the preferred market microstructure.

ENDS

Notes for Editors: ‘Trading Costs of Institutional Investors in Auction and Dealer Markets’ by Andy Snell and Ian Tonks is published in the July 2003 issue of the Economic Journal.

Snell is at the University of Edinburgh; Tonks is at the Centre for Market and Public Organisation at the University of Bristol.

For Further Information: contact Ian Tonks on 0117-928-8435 (home: 01225-422196; email: I.Tonks@bristol.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:romesh@compuserve.com.