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Market liquidity and trader welfare in multiple dealer markets: evidence from dual trading restrictions

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Abstract

Dual trading is the practice whereby futures floor traders execute trades both for their own and customers' accounts on the same day. We provide evidence, in the context of restrictions on dual trading, that aggregate liquidity measures, such as the average bid-ask spread, may be misleading indicators of traders' welfare in markets with multiple, heterogeneously skilled dealers. In our theoretical model, hedgers and informed customers trade through futures floor traders of different skill levels: more skilled floor traders attract more hedgers to trade. We show that customers' welfare and dual trader revenues are increasing in the skill level and, so, a restriction on dual trading is welfare-reducing for customers of dual traders with above-average skill levels. Yet, our results further show, the restriction may leave market depth unchanged if the difference in average skill levels between dual traders and pure brokers in not large. ; We empirically study two episodes of dual trading restrictions and find that dual traders were heterogeneous with respect to their personal trading skills. Further, although the average realized bid-ask spread was unchanged in both these episodes, restrictions may have hurt dual traders of above-average skills and their customers. Specifically, we find that dual traders with above-average skills may have quit brokerage and switched to trading for their own accounts following restrictions, as conjectured by Grossman (1989).

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  • Peter Locke & Asani Sarkar & Lifan Wu, 1997. "Market liquidity and trader welfare in multiple dealer markets: evidence from dual trading restrictions," Research Paper 9721, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednrp:9721
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    Cited by:

    1. Chakravarty, Sugato & Li, Kai, 2003. "An examination of own account trading by dual traders in futures markets," Journal of Financial Economics, Elsevier, vol. 69(2), pages 375-397, August.
    2. Qin Zhang & Jin Boon Wong, 2023. "The influence of oil price uncertainty on stock liquidity," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(2), pages 141-167, February.
    3. Chakravarty, Sugato & Li, Kai, 2003. "A Bayesian analysis of dual trader informativeness in futures markets," Journal of Empirical Finance, Elsevier, vol. 10(3), pages 355-371, May.
    4. Qin Zhang & Jin Boon Wong, 2022. "Do oil shocks impact stock liquidity?," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(3), pages 472-491, March.

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