Dynamic Market Making and Asset Pricing

Abstract
We develop a dynamic model of market making with asymmetric information and imperfectly competitive market makers. Our model captures key features of market making in many financial markets: in the presence of information asymmetry and limited risk-bearing capacity, market makers optimally make offsetting trades in bid and ask markets by adjusting bid and ask prices/depths to avoid the risk of holding inventories. We solve for equilibrium endogenous bid and ask prices and trading volume analytically. Consistent with empirical findings, we find that when market makers have significant market power, other traders optimally smooth out their trading even though they are not strategic. The market power of market makers dampens and spreads out trading spikes due to either new information arrivals or liquidity shocks. Consequently, trading persists even after arrivals of information and liquidity shocks. In addition, traders tend to trade quickly on their private information while postponing their hedging trades until later periods. As a result, both trading volume and bid-ask spread may exhibit U-shaped patterns. Higher trading frequency mitigates market makers' market power, and thus decreases bid and ask spreads and increases total trading volume. Therefore, while more trading rounds make other traders better off, they may make market makers worse off.