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

Sascha Baghestanian, Paul Gortner and Baptiste Massenot ()

No 108, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

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. Investors face a trade-off between risk and return. At the benefit of a potentially higher return, they can entrust their money to a trader. However this investment is risky, as the trader might not be trustworthy. Alternatively, they can opt for a safe but low return. We study how subjects solve this trade-off when traders are either liable for losses or not, and when their bonuses are either capped or not. Limited liability introduces a conflict of interest because it 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 decrease prices. In contrast to these predictions, we find that under limited liability investors contribute to asset price bubbles by increasing liquidity provision and that caps fail to tame bubbles. Overall, giving investors skin in the game fosters financial stability.

Keywords: compensation; liquidity; experimental asset markets; bubbles (search for similar items in EconPapers)
JEL-codes: C90 C91 D03 G02 G12 (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-exp
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:108

DOI: 10.2139/ssrn.2613432

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