Call and Continuous Trading Mechanisms Under Asymmetric Information: An Experimental Investigation

I examine the relative performance of call and continuous auctions under asymmetric information by manipulating trading rules and information sets in laboratory asset markets. I find significant differences in an environment that extends the Kyle (1985) framework to permit the exogenous liquidity trading motive to have a natural economic interpretation. The adverse selection costs incurred by noise traders are significantly lower under the call auction, despite no significant reduction in average price efficiency. This result suggests that discussions of the costs and benefits of insider trading should take place within the context of a specific trading mechanism. UNDERSTANDING THE INFLUENCE of the trading process on the price formation process is a fundamental goal of the large microstructure literature. An important feature of much of this work has been the replacement of the "Walrasian auctioneer" of general equilibrium theory with market makers who stand ready to provide liquidity and immediacy when buy and sell orders are imperfectly synchronized. In this framework, the presence of agents with "inside information" has an important influence on market liquidity and the price formation process. Seminal theoretical works here include Glosten and Milgrom (1985) and Kyle (1985). A primary purpose of this study is to extend this work by examining the behavior of competitive market makers under alternative trading arrangements that differ on the fundamental dimension of whether orders are temporally consolidated prior to execution. The method of inquiry is experimental economics. The two mechanisms I investigate are a call auction, in which all buy and sell orders arriving during a specified interval are batched and executed at a single price, and a continuous auction, in which each buy and sell order is executed upon arrival. Both mechanisms are widely employed. While a call auction is the primary trading mechanism on many continental European stock exchanges, the growing Nasdaq over the counter (OTC) market relies exclusively on a continuous mechanism. In addition, hybrid systems that