On Dealer Markets Under Competition
THOMAS HO and HANS R. STOLL*
SECURITIESMARKETS arise to economize on the costs of trading by investors.These costs include the cost of communicating bids and offers,the cost of waiting,and the cost of transferring title. In a call auction market, trading is at periodic time intervals. In a continuous market, trading is possible at any time. A continuous market requires the existence of at least one unexecuted limit order on the buy side and on the sell side. In U.S. markets, these limit orders are often placed by a dealer. Indeed in the over-the-counter (OTC) market, dealer bid and ask quotes constitute the market. On the New York Stock Exchange (NYSE),the best bid or ask price may be that of the specialist or one of the orders in his limit order book. Whether the bid or ask price is set by the dealer or an investor, the factors determining that price are the same. However,because of his proximity to the market the dealer would generally be expected to be able to offer better prices than an ordinary investor faced with higher communication, waiting and transfer costs. Thus, this paper is phrased in terms of dealer, but the broader applicability to any set of investors placing limit orders is implicit.