Introduction

An economist's immediate picture of a speculative market is that of a Walrasian auction: all market participants submit their orders to buy and to sell, and an anonymous auctioneer finds the price that balances supply and demand. However, in practice many speculative markets are run by market making dealers, who quote bid and ask prices and stand ready to satisfy incoming orders at the stated quotes. Practitioners often describe the difference between the two market regimes by referring to auction markets as ‘order-driven’ and to dealership markets as ‘quote-driven’ markets.

Does the difference between these two market systems have substantive economic implications? For instance, are the differences between the two systems so great as to result in a different set of transactions, asset prices, and welfare consequences for market participants? The existing literature on these issues is quite thin, possibly because the auction and the dealership systems differ along many dimensions, and in rather subtle ways.

A reflection of this can be seen in the lack of clear agreement on what really distinguishes the two systems from an economic standpoint. In some models, the distinctive feature of dealership markets is that bid and ask prices are constrained to be constant, independent of aggregate trading volume (Pythiachariyakul, 1986; Mendelson, 1987). But in practice dealers do quote prices that depend on the size of transactions: the bid–ask spread is known to widen for orders of large size.