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Compensation Schemes, Liquidity Provision, and Asset Prices: An Experimental Analysis

Experimental Economics, Vol. 20, Issue 2, pp. 481-505

Authors:
Sascha Baghestanian,
Paul Gortner,
Baptiste Massenot
Research Area:
Law and Finance, Experiment Center
Date:
Jun 2017
Keywords:
compensation, liquidity, experimental asset markets, bubbles
Abstract:

In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices, two outcomes that are important for financial stability. Compensation schemes can drive a wedge between how investors and traders value the asset. Limited liability makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and increase prices. In contrast to these predictions, we find that under limited liability investors increase liquidity provision and asset price bubbles are larger. Bonus caps have no clear effect on liquidity provision and they fail to tame bubbles. Overall, giving traders skin in the game fosters financial stability.

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