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Market Making with Costly Monitoring: An Analysis of the SOES Controversy

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  • Thierry Foucault
  • Ailsa Röell
  • Patrik Sandås

Abstract

This article presents a model of information monitoring and market making in a dealership market. We model how intensively dealers monitor public information to avoid being picked off by professional day traders when monitoring is costly. Price competition among dealers is hampered by their incentives to share monitoring costs. The risk of being picked off by the day traders makes dealers more competitive. The interaction between these effects determines whether a firm quote rule improves trading costs and price discovery. Our empirical results support the prediction that professional day traders prefer stocks with small spreads, but offer less support for the prediction that their trading leads to wider spreads. Copyright 2003, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhg005
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Bibliographic Info

Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 16 (2003)
Issue (Month): 2 ()
Pages: 345-384

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Handle: RePEc:oup:rfinst:v:16:y:2003:i:2:p:345-384

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References

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  1. Kandel, Eugene & Marx, Leslie M., 1997. "Nasdaq market structure and spread patterns," Journal of Financial Economics, Elsevier, vol. 45(1), pages 61-89, July.
  2. Grossman, Sanford J, et al, 1997. "Clustering and Competition in Asset Markets," Journal of Law and Economics, University of Chicago Press, vol. 40(1), pages 23-60, April.
  3. Dennert, Jurgen, 1993. "Price Competition between Market Makers," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 735-51, July.
  4. Copeland, Thomas E & Galai, Dan, 1983. " Information Effects on the Bid-Ask Spread," Journal of Finance, American Finance Association, vol. 38(5), pages 1457-69, December.
  5. Harris, Jeffrey H. & Schultz, Paul H., 1998. "The trading profits of SOES bandits," Journal of Financial Economics, Elsevier, vol. 50(1), pages 39-62, October.
  6. Kandel, Eugene & M. Marx, Leslie, 1999. "Odd-eighth avoidance as a defense against SOES bandits," Journal of Financial Economics, Elsevier, vol. 51(1), pages 85-102, January.
  7. Michael J. Barclay & William G. Christie & Jeffrey H. Harris & Eugene Kandel & Paul H. Schultz, 1999. "Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks," Journal of Finance, American Finance Association, vol. 54(1), pages 1-34, 02.
  8. Battalio, Robert H. & Hatch, Brian & Jennings, Robert, 1997. "SOES Trading and Market Volatility," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(02), pages 225-238, June.
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Citations

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Cited by:
  1. Fong, Kingsley Y.L. & Liu, Wai-Man, 2010. "Limit order revisions," Journal of Banking & Finance, Elsevier, vol. 34(8), pages 1873-1885, August.
  2. Foucault, Thierry & Moinas, Sophie & Theissen, Erik, 2003. "Does Anonymity Matter in Electronic Limit Order Markets?," CEPR Discussion Papers 4091, C.E.P.R. Discussion Papers.
  3. Vaihekoski, Mika, 2008. "History of finance research and education in Finland: The first thirty years," Research Discussion Papers 18/2008, Bank of Finland.
  4. Benston, George J. & Wood, Robert A., 2008. "Why effective spreads on NASDAQ were higher than on the New York stock exchange in the 1990s," Journal of Empirical Finance, Elsevier, vol. 15(1), pages 17-40, January.
  5. Garvey, Ryan & Wu, Fei, 2010. "Speed, distance, and electronic trading: New evidence on why location matters," Journal of Financial Markets, Elsevier, vol. 13(4), pages 367-396, November.
  6. Erenburg, Grigori & Lasser, Dennis, 2009. "Electronic limit order book and order submission choice around macroeconomic news," Review of Financial Economics, Elsevier, vol. 18(4), pages 172-182, October.
  7. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 44621, University Library of Munich, Germany, revised Jan 2013.
  8. Terrence Hendershott & Charles M. Jones & Albert J. Menkveld, 2011. "Does Algorithmic Trading Improve Liquidity?," Journal of Finance, American Finance Association, vol. 66(1), pages 1-33, 02.
  9. Mika Vaihekoski, 2011. "History of financial research and education in Finland," The European Journal of Finance, Taylor & Francis Journals, vol. 17(5-6), pages 339-354.
  10. Liu, Wai-Man, 2009. "Monitoring and limit order submission risks," Journal of Financial Markets, Elsevier, vol. 12(1), pages 107-141, February.
  11. Brogaard, Jonathan & Hendershott, Terrence & Riordan, Ryan, 2013. "High frequency trading and price discovery," Working Paper Series 1602, European Central Bank.
  12. Hendershott, Terrence & Moulton, Pamela C., 2011. "Automation, speed, and stock market quality: The NYSE's Hybrid," Journal of Financial Markets, Elsevier, vol. 14(4), pages 568-604, November.
  13. Hoffmann, Peter, 2012. "A dynamic limit order market with fast and slow traders," MPRA Paper 39855, University Library of Munich, Germany.

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