PRICE-COMPETITION BETWEEN MARKET MAKERS

The paper explicitly models price competition in financial markets in which prices are quoted by competing dealers before future demand is observed. The strategic behaviour of informed insiders and uninformed liquidity traders implies that a growing number of market makers leads to a higher risk exposure for the individual market maker which induces higher individual bid-ask-spreads and higher transaction costs for the liquidity traders. Under certain conditions liquidity traders would prefer a monopolistic market maker rather than several competing market makers. The results hold under various assumptions on the strategy space of the market makers.