Working Orders in Limit Order Markets and Floor Exchanges

We analyze limit order markets and floor exchanges, assuming an informed trader and discretionary liquidity traders use market orders and can either submit block orders or work their demands as a series of small orders. By working their demands, large market order traders pool with small traders. We show that every equilibrium on a floor exchange must involve at least partial pooling. Moreover, there is always a fully pooling (worked order) equilibrium on a floor exchange that is equivalent to a block order equilibrium in a limit order market. THE GOAL OF THIS PAPER IS TO COMPARE ALTERNATIVE MARKET designs. Glosten (1994) shows that a market with an open limit order book is robust to competition from other markets. Our principal result is that other market types may mimic an open limit order book and hence have the same robustness. In particular, following Glosten (1994) and assuming perfect competition among risk-neutral liquidity providers, a uniform price auction has an equilibrium that is equivalent in all important respects to the equilibrium of an open limit order book. We argue below that uniform pricing is an essential feature of a floor exchange, and thus an equivalence between (stylized models of) limit order markets and floor exchanges obtains. In these stylized models, the distinction between limit order markets and floor exchanges is that pricing in a limit order market is discriminatory (each limit order executes at its limit price rather than the marginal price) whereas pricing on a floor exchange is uniform (all shares in a trade execute at the same price). Note that we do not model other important distinctions between limit order markets and floor exchanges, in particular, the anonymity of orders (and hence the potential for building reputations) and the extent to which orders are revealed (and hence the opportunity for front running).1 ∗Back is at Mays Business School, Texas A&M University; Baruch is at David Eccles School of Business, University of Utah and was visiting at the Bendheim Center for Finance at Princeton University when much of the work on this paper was done. We thank Rob Stambaugh (the editor), an anonymous associate editor, and two anonymous referees for helpful comments. We also thank seminar participants at the University of Colorado, Carnegie Mellon University, Cornell University, Ecole Supérieure de Commerce de Toulouse, Princeton University, Rutgers University, Technion Haifa, Univeristá di Torino, the University of Illinois, the NBER Market Microstructure Group Meeting, and the Center for Financial Studies Market Design Conference. 1 See Benveniste, Marcus, and Wilhelm (1992) for an analysis of the role of reputation on a floor exchange.