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

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Author Info
FOUCAULT, Thierry
RÖELL, Ailsa
SANDAS, Patrik

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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 pick off "stale quotes". Externalities associated with monitoring give rise to multiple equilibria in which dealers earn strictly positive expected profits. We obtain various policy implications. A switch to automatic execution can improve or worsen spreads and price discovery depending on the specific equilibrium. A reduction in the minimum quoted depth tightens the spread but it reduces price efficiency. Our analysis is relevant for the SOES controversy given that speculators in our model behave as the real world SOES "bandits". Our model predicts that SOES bandits should trade in stocks with small spreads and that SOES bandit activity should widen the spread. We provide empirical evidence consistent with these predictions.

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Publisher Info
Paper provided by HEC Paris in its series Les Cahiers de Recherche with number 702.

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Length: 52 pages
Date of creation: 01 Apr 2000
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Handle: RePEc:ebg:heccah:0702

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Postal: HEC Paris, 78351 Jouy-en-Josas cedex, France
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Related research
Keywords: Monitoring; bid-ask spread; automatic execution; Soes trading;

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Find related papers by JEL classification:
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications
E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Grossman, Sanford J, et al, 1997. "Clustering and Competition in Asset Markets," Journal of Law & Economics, University of Chicago Press, vol. 40(1), pages 23-60, April.
  2. Harris, Jeffrey H. & Schultz, Paul H., 1998. "The trading profits of SOES bandits1," Journal of Financial Economics, Elsevier, vol. 50(1), pages 39-62, October. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
  4. 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. [Downloadable!]
  5. Kandel, Eugene & Marx, Leslie M., 1997. "Nasdaq market structure and spread patterns," Journal of Financial Economics, Elsevier, vol. 45(1), pages 61-89, July. [Downloadable!] (restricted)
  6. Kandel, Eugene & M. Marx, Leslie, 1999. "Odd-eighth avoidance as a defense against SOES bandits1," Journal of Financial Economics, Elsevier, vol. 51(1), pages 85-102, January. [Downloadable!] (restricted)
  7. 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. [Downloadable!] (restricted)
  8. Dennert, Jurgen, 1993. "Price Competition between Market Makers," Review of Economic Studies, Blackwell Publishing, vol. 60(3), pages 735-51, July. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Thierry, FOUCAULT & Sophie, MOINAS & Erik, THEISSEN, 2003. "Does anonymity matter in electronic limit order markets ?," Les Cahiers de Recherche 784, HEC Paris. [Downloadable!]
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