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December 1, 1998

How The First Best Market Works

By John A. Byrne

The following is an example of how the proposed First Best Market Concept would work:

Assume that there are five firms making a market in ABCD Corporation. For ease of example, each of the five traders has a bid of one dollar and an ask of one dollar fifty cents ($1 1/2). If, for example, MMA (market maker A) has developed a short position of 10,000 shares at $1 1/2, it would make economic sense for MMA to raise its bid to $1 1/8 or more to induce someone to sell that stock.

However, if MMB (maker maker B) has preference in that security because MMB pays two cents a share to retail broker dealer A or BDA, MMA may not have sufficient incentive to raise its price.

Assume that MMA does not raise its bid, which it would have under the First Best Market approach, where it would be assured of attracting the first order to sell. In that instance, BDA directs its order to MMB and the execution occurs at $1. BDA makes an additional $20 per 1,000 shares sold, and the customer loses at least $125 per 1,000 shares sold.

Remember, there is no economic reason for MMA to raise its bid if there is no linkage with receipt of the first order to sell. Of course MMB will not raise its bid, because it will get the order in any case.

Note: Example originally appeared in the First Best Market Concept discussion paper.