The optimal bid/ask spread in a Specialist System

a r t i c l e i n f o In this work we propose a simple market model where some features of the Specialist System are analyzed. In particular, the specialist's obligation to display bid/ask quotes on the book within the bounds imposed by the Exchange is considered. The proposed model allows to analyze the effects of the specialist's interventions on the short term dynamics of bid/ask prices and address a relevant market design issue, that is determination and analysis of the optimal endogenous upper bound that – according to economic conditions – should be imposed by Stock Exchange on the quoted bid/ask spread. The institutional details are summarized in a few structural parameters and the focus is on the aggregate effects of excess demand/supply. The architecture of Stock Exchanges represents a key issue which continues to receive great attention in theoretical and empirical literature, especially during time periods characterized by financial turmoil. Over the past fifteen years, research in this area has focused mainly on the impact of alternative trading systems on market quality and efficiency, since one of the most important factors characterizing the development of financial markets has been the proliferation of new markets and automated trading systems. Many automated markets use a pure order driven system characterized by a high degree of transparency, in which public limit orders are continuously displayed. Some other markets also offer the alternative of trading under a hybrid order driven system with a specialist and limit order book. Stocks traded in a hybrid order driven system are usually sampled on the basis of certain parameters subject to annual review (i.e. capitalization, average quoted bid/ask spread, daily average trading volume, turnover, market touch, floating supply, etc.) and ranked into bands of liquidity (Nimalendran and Petrella, 2003, for a detailed description). Under this scheme, the specialist has the duty to continuously display ask and bid prices on the book and negotiate a minimum lot of shares daily. Maximum spread and minimum number of lots per day are commonly determined by some Stock Exchanges. The bid/ask quotes are posted by the specialist on the limit order book for being displayed on trading terminals to all market participants. Accordingly, specialist is not monopolistic in managing and displaying the book since any intermediary has access to electronic limit order book and can place limit orders that compete with the specialist's quotes. Specialists are generally …