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

Published online by Cambridge University Press:  14 March 2025

Sascha Baghestanian ,
Paul Gortner  and
Baptiste Massenot
Sascha Baghestanian*
Affiliation:
Goethe University Frankfurt, Frankfurt, Germany
Paul Gortner*
Affiliation:
Goethe University Frankfurt, Frankfurt, Germany
Baptiste Massenot*
Affiliation:
Goethe University Frankfurt, Frankfurt, Germany
*
baghestanian@econ.uni-frankfurt.de
paulgortner@gmx.de
baptistemassenot@gmail.com
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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.

Keywords

CompensationLiquidityExperimental asset marketsBubbles

JEL classification

G12: Asset Pricing • Trading Volume • Bond Interest Rates C91: Laboratory, Individual Behavior C90: General
Type
Original Paper
Information
Experimental Economics , Volume 20 , Issue 2 , June 2017 , pp. 481 - 505
Copyright
Copyright © 2016 Economic Science Association

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Footnotes

Electronic supplementary material The online version of this article (doi:https://doi.org/10.1007/s10683-016-9493-0) contains supplementary material, which is available to authorized users.

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