Who Benefits from an Open Limit-Order Book?

The NYSE has opened the limit-order book to off-exchange traders during trading hours. In this paper, we address the welfare implications of the recent change in market structure. We model a market similar to the single-price auction that the exchange uses to open the trading day. We consider two different environments. In the first, only the specialist can see the limit order book, while in the second the information in the book is available to all traders. We then compare equilibria. We find that traders who demand liquidity are better off when the book is open, while traders who supply liquidity (limit-order traders and the specialist) are better off when the book is closed. We also find that, on average, the opening price is more informative in the open book environment. The empirical implications with an open limit-order book are: 1) Opening prices are more informative; 2) Price impacts of market orders are smaller; and 3) The adverse-selection component of price impacts of market orders are larger. ∗Department of Finance, David Eccles School of Business, University of Utah, Salt Lake City, UT 84112. e-mail [email protected]. I am grateful to Kerry Back for his guidance. I wish to Hank Bessembinder, Phil Dybvig, Michel Habib, Eric Hughson, Kenneth Kavajecz, Pete Kyle, Mike Lemmon, Venkatesh Panchapagesan, Gideon Saar, and Raj Singh. An earlier version of this paper was presented at the annual meeting of the American Finance Association, January 1998.