The effects of market-making on price dynamics

Abstract

This paper studies market-makers, agents responsible for maintaining liquidity and orderly price transitions in markets. Market-makers include major firms making markets on global stock exchanges, as well as software agents that run behind the scenes on novel electronic markets like prediction markets. We use a sophisticated model of marketmaking to build richer agent-based models of markets and show how these models can be useful both in understanding properties of existing markets and in predicting the impacts of structural changes. For example, we show how competition among market-makers can lead to significantly faster price discovery following a jump in the true value of an asset. We also show that myopic profit-maximization, apart from leading to poor market quality, is sub-optimal even for a monopolistic market-maker. This observation leads to an interesting characterization of the market-maker’s explorationexploitation dilemma as a tradeoff between price discovery and profit-taking.

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