DP2265 Imperfect Market Monitoring and SOES Trading

Author(s):	Thierry Foucault, Ailsa A Röell, Patrik Sandås
Publication Date:	October 1999
Keyword(s):	Automatic Execution, Bid-Ask Spread, Monitoring, SOES
JEL(s):	G10, G14, G24, L13
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=2265

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'.