Working Paper: CEPR ID: DP2265
Authors: Thierry Foucault; Ailsa Rell; Patrik Sands
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 behaviour of speculators in our model is very similar to the alleged behaviour of the real world SOES 'bandits'.
Keywords: monitoring; bid-ask spread; automatic execution; SOES
JEL Codes: G10; G14; G24; L13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| imperfect monitoring by market makers (D43) | profit opportunities for speculators (D84) |
| market monitoring (L10) | expected profits for dealers and speculators (D84) |
| increased monitoring (E63) | better pricing (D49) |
| increased monitoring (E63) | risk of being picked off by speculators (G13) |
| dealer protection from stale quotes (G33) | larger spreads (F12) |
| dealer protection from stale quotes (G33) | hindered price discovery (D41) |
| reduction in minimum quoted depth (L72) | decrease spreads (E43) |
| reduction in minimum quoted depth (L72) | increase speculator trading frequency (D84) |