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Imperfect Market Monitoring and SOES Trading

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Author Info

  • FOUCAULT, Thierry
  • RÖELL, Ailsa

    (Princeton University)

  • SANDAS, Patrik

    (The Wharton School)

Abstract

We develop a model of price formation in a dealership market where monitoring of the information flow requires costly effort. The result is imperfect monitoring, which creates profit opportunities for speculators, who do not act as dealers but simply monitor the information flow and quote updates in order to pick off stale quotes. Externalities associated with monitoring can help to sustain non-competitive spreads. We show that protecting dealers against the execution of stale quotes can result in larger spreads and be detrimental to price discovery due to externalities in monitoring. A reduction in the minimum quoted depth will reduce the spread and speculators' trading frequency. Our analysis is relevant for the SOES debate given that the behavior of speculators in our model is very similar to the alleged behavior of the real world SOES bandits.

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File URL: http://www.hec.fr/var/fre/storage/original/application/5714fdda1f89a6dd088e7e393c0ee03b.pdf
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Bibliographic Info

Paper provided by HEC Paris in its series Les Cahiers de Recherche with number 671.

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Length: 56 pages
Date of creation: 01 Aug 1999
Date of revision:
Handle: RePEc:ebg:heccah:0671

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Postal: HEC Paris, 78351 Jouy-en-Josas cedex, France
Web page: http://www.hec.fr/
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Related research

Keywords: monitoring; bid-ask spread; automatic execution; SOES trading;

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References

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  1. 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.
  2. 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.
  3. 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.
  4. Kandel, Eugene & Marx, Leslie M., 1997. "Nasdaq market structure and spread patterns," Journal of Financial Economics, Elsevier, vol. 45(1), pages 61-89, July.
  5. 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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Cited by:
  1. Liu, Wai-Man & Sawyer, K. R., 2003. "How free are free trading options?," Pacific-Basin Finance Journal, Elsevier, vol. 11(5), pages 573-591, November.

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