Compensation schemes, liquidity provision, and asset prices: an experimental analysis

Abstract

The recent financial crisis highlighted the importance of compensation schemes for excessive risk taking in the financial industry, with consequences on asset price bubbles (Rajan, 2006;Bebchuk, 2009). To foster financial stability, a number of reforms have been discussed. Bonus caps have received the most attention and are now being implemented in the European Union. Another proposition suggests giving bankers more skin in the game, by making them liable for losses.In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes of traders affect liquidity provision and asset prices. Traders can trade assets that yield dividends and thus potentially high returns. As a consequence, investors face a trade-off between either entrusting their money and enjoying potentially higher returns but with the risk of dealing with an untrustworthy trader, or keeping their money and receiving a safe but low return.We study how subjects solve this trade-off under different compensation schemes. First, we vary the extent to which traders are liable for losses. The introduction of limited liability creates a conflict of interest between the trader and the investor, because they value assets differently. Since traders have no downside risk, they highly value assets and are willing to buy them at a high price. By contrast, investors suffer all the losses while they share the gains. They are thus willing to pay less than traders. Since they anticipate that traders are ready to pay more, they can restrict liquidity provision to bring prices more in line with their valuation. Introducing limited liability should thus result in higher asset prices or lower liquidity provision if investors discipline traders.We also study the effect of capping gains. A cap generates a different type of conflict of interest. It reduces the potential gains of the trader and increases those of the investor. Assets become less valuable to traders which can thus decrease the pressure on prices. At the same time, assets become more valuable to investors, who become willing to provide more liquidity. While caps can have the desired effect of reducing risk taking by traders, the higher liquidity could, at the same time, increase pressure on prices.First, we find that liquidity provision is lowest when traders are liable for losses. This is unexpected given the absence of conflict of interest. Trust should be the highest. Liquidity provision is higher in the presence of a cap and/or limited liability. This implies that investors fail to discipline traders in the presence of limited liability. Also, the cap seems to improve liquidity provision by making the asset more valuable to investors. Second, we find that asset prices are closer to the fundamental value when traders are liable for losses than under limited liability. This suggests that, as expected, traders take more risk when they are not liable for losses. Furthermore, the higher liquidity entrusted to traders increases asset prices. We indeed find...

A heterogeneous artificial stock market model can benefit people against another financial crisis

“…Despite the research on the macro factors to evaluate the impact of financial stability [ 6 , 7 ], little exists in the literature to assess the impact of financial crisis on the microstructure by agent-based models (ABM) [ 8 ]. The financial market is a particularly good application for ABM method.…”