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: www.cepr.org/pubs/dps/DP2265.asp

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'.