Competing Market Makers, Liquidity Provision, and Bid-Ask Spread

This paper develops a dynamic market microstructure model of liquidity provision in which M strategic market makers compete in price schedules for order flow from informed and uninformed traders. In equilibrium, market makers post price schedules that are steeper than efficient ones, and the market bid-ask spreads can be decomposed into two components, one due to adverse selection and the other due to imperfect competition. At any time, the two components are proportional to each other with a coefficient of proportionality depending on M. Several testable hypothesis are derived regarding the time-series and cross-sectional properties of prices and the bid-ask spreads. In particular, a new empirical measure of market competitiveness is proposed which can be estimated from the history of transaction prices and trading volumes. Finally, the properties of continuous market are also investigated