Bid-ask Spreads with Indirect Competition among Specialists

We examine the prices quoted by specialists (or dealers) who have monopoly power to set prices (bids and asks) for a given asset, but who face indirect competition from other specialists who trade in related assets. In the context of a simple model where investors have mean{variance preferences, we characterize the equilibrium bids and asks quoted by K specialists in N assets, where some specialists may control more than one asset. We compare the equilibrium spreads as the number (and factor structure) of the assets each specialist controls is varied. It is shown that for some constellations of initial portfolio holdings and asset covariance it is socially preferred to have competing specialists, while for others it is socially preferred to have their actions coordinated (or to have one specialist control several assets). In a simple factor model, we show how the optimal specialist control structure depends on whether the assets trade as substitutes or complements. In some situations it is bene cial to have specialist power concentrated within industries, in other situations, across industries, and in yet other situations, not to be concentrated at all. 1 A liations { Gehrig: Volkswirtschaftliches Institut-WWZ, Universitat Basel, Petersgraben 51, CH-4003 Basel, Switzerland. Jackson: MEDS, Kellogg Graduate School of Management, Northwestern University, Evanston IL 60208{2009, USA. 2 We would like to thank the participants of several seminars for helpful comments that have led to a substantial improvement of the content and exposition of the results herein. Gehrig gratefully acknowledges nancial support of the Schweizerischer Nationalfonds under grant 8210-033266. Jackson gratefully acknowledges nancial support of the National Science Foundation under grant SBR-9223338. This work was begun while Gehrig visited Northwestern University and was completed while Jackson was visiting the California Institute of Technology: We are grateful for their hospitality.