S. Viswanathan
Duke University, Durham, NC 27708
James J.D. Wang
Duke University
ABSTRACT
We study whether two-stage trading mechanisms that involve inter-dealer trading after a customer-dealer trade provide welfare improvement for the customers over the one-shot settings traditionally analyzed in the market microstructure literature. The opportunity to retrade produces a distortion that is absent in one-shot trading environments -- there is a "quanity bias" in that dealer who initially fills the customer order will retain an above-average fraction of it at the end of inter-dealer trading. This causes the dealers to engage in more heightened price competition during inter-dealer trading. Whether such a "competition effect" is sufficient to cause a risk neutral customer to prefer two-stage trading depends on the pricing rules of the inter-dealer market, the distribution of ex ante inventories, and the size of the customer order.
In general, the customer favors two-stage trading when the dispersion in ecx ante dealer inventories is small. When inter-dealer trading is of the uniform-price type, two-stage trading dominates one-shot trading for large order flows. When inter-dealer trading is run as a limit-order book, however, it provides the customer welfare improvement for relatively small outside orders. These conclusions about the relative advantages of two-step procedures are qualitifed by the fact that inter-dealer trading tends to exacerbate the adverse selection problems between the customer and the dealers.