Oligopolistic market-making and inventory heterogeneity

Abstract

This article examines market making under imperfect competition. A novel dataset on detailed individual-level intraday market-making helps to raise new questions on aspects of liquidity in the environment. The paper suggests a dynamic duopoly market-making model. The general form of the equilibrium is characterized. The exogenous parameters of the model are estimated based on the data. Two different Markov equilibria are analyzed. The distribution of inventories plays a crucial role in defining the strategic competitive behavior of agents and observed liquidity provision. Tight capital constraints can generate "resting" behavior for a market maker. Under relaxed capital constraints, the width of the bid-ask spread positively correlates with inventory imbalances. A grim-trigger non-Markov equilibrium is analyzed. Collusive-behavior of market makers raises liquidity price but dries up its variation. FE estimation at aggregate and account level confirms that inventory distribution affects market makers activity and aggregate liquidity. I am very grateful to Hui Chen and Leonid Kogan for their guidance and support. I also thank Allison Cole, Daniel Greenwald, Pierre Jaffard, Anton Petukhov, Lawrence Schmidt, Tim de Silva, Adrian Verdelhan, Jiaheng Yu, Haoxiang Zhu, and seminar participants at the MIT finance seminar for comments and suggestions.