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

Author

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  • Thierry Foucault

    () (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

  • Ailsa Röell

    (Department of economics - Princeton University)

  • Patrik Sandas

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.

Suggested Citation

  • Thierry Foucault & Ailsa Röell & Patrik Sandas, 2000. "Market Making with Costly Monitoring: An Analysis of the SOES Controversy," Working Papers hal-00601494, HAL.
  • Handle: RePEc:hal:wpaper:hal-00601494
    Note: View the original document on HAL open archive server: https://hal-hec.archives-ouvertes.fr/hal-00601494
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    References listed on IDEAS

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    1. Grossman, Sanford J & Miller, Merton H & Cone, Kenneth R & Fischel, Daniel R & Ross, David J, 1997. "Clustering and Competition in Asset Markets," Journal of Law and 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 bandits," Journal of Financial Economics, Elsevier, vol. 50(1), pages 39-62, October.
    3. Copeland, Thomas E & Galai, Dan, 1983. "Information Effects on the Bid-Ask Spread," Journal of Finance, American Finance Association, vol. 38(5), pages 1457-1469, December.
    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. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, December.
    6. Jürgen Dennert, 1993. "Price Competition between Market Makers," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 735-751.
    7. 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.
    8. 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, February.
    9. Battalio, Robert H. & Hatch, Brian & Jennings, Robert, 1997. "SOES Trading and Market Volatility," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(2), pages 225-238, June.
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    More about this item

    Keywords

    SOES trading; automatic execution; Monitoring; bid-ask spread;

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

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