Market Making, Liquidity Provision, and Attention Constraints: An Experimental Study

Abstract

This paper uses an experimental electronic market to investigate the effect of limited attention on the market maker’s ability to provide liquidity and, thus, on aggregate market liquidity. I find that higher demands on the market maker’s attention worsen her ability to provide liquidity but do not reduce the aggregate level of market liquidity. This effect is only significant in less active markets. Furthermore, the aggregate level of market liquidity remains unaltered across both highly active and inactive markets, suggesting a reactive strategy by informed traders who step in to compete with market makers during high information intensity periods when their attention allocation efforts are compromised. In fact, in markets with a higher information value, the effect of attention constraints on the liquidity provision ability of market makers is greater. This implies that informed traders may not only exploit their informational advantage against uninformed traders but they may also use it to reap a higher share of liquidity-based profits. Finally, the market maker’s trading performance measured by her profit share and ability to manage her inventory worsens when demands on her attention are greater.