Risk Aversion, Transparency, and Market Performance

Abstract

Using a model of market making with inventories based on Biais (1993), we find that investors obtain more favorable execution prices, and they hence invest more, when markets are fragmented. In our model, risk-averse dealers use less aggressive price strategies in more transparent markets (centralized) because quote dissemination alleviates uncertainty about the prices quoted by other dealers and, hence, reduces the need to compete aggressively for order flow. Further, we show that the move toward greater transparency (centralization) may have detrimental effects on liquidity and welfare.

Finding a Good Price in Opaque Over-the-Counter Markets

“…For example, in the dealer-market models of Biais (1993), de Frutos andManzano (2002), Yin (2005), and Green (2007), the quote providers commit to their original quotes when the quote seeker returns. In this paper, as in functioning OTC market for financial securities, a rejected quote lapses immediately.…”

Transparency matters: Price formation in the presence of order preferencing

“…11 For tractability reasons, the direct effect of risk aversion on preferences is removed by using the first order linear approximation proposed by Biais (1993) and used by Rhodes-Kropf (2005), or Yin (2005). See de Frutos and Manzano (2002) for an analysis of the impact of risk aversion in the inventory model of Biais (1993). Dealer 2's trading profit differs from dealer 1's.…”

Central clearing and CDS market quality

“…There are, however, theoretical studies suggesting that the impact of transparency is either redundant (Biais, 1993), ambiguous (De Frutos & Manzano, 2002Lyons, 1996;Madhavan, 1995Madhavan, , 1996Naik, Neuberger, & Viswanathan, 1999;Rindi, 2008), or even detrimental for market quality. In the model developed by Brunnermeier and Pedersen (2005), some 5 The degree of legal and operational standardization should also augment with central clearing.…”