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Rev Fin 2003; 16:345-384
© 2003 the Society for Financial Studies

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

Thierry Foucault
HEC School of Management and CEPR

Ailsa Röell
Princeton University and CEPR

Patrik Sandås
University of Pennsylvania and CEPR

Address correspondence to: Patrik Sandås, Finance Department, The Wharton School, University of Pennsylvania, Steinberg Hall–Dietrich Hall, Philadelphia, PA 19104, or e-mail: sandas{at}wharton.upenn.edu.

Abstract

This article presents a model of information monitoring and market making in a dealership market. We model how intensively dealers monitor public information to avoid being picked off by professional day traders when monitoring is costly. Price competition among dealers is hampered by their incentives to share monitoring costs. The risk of being picked off by the day traders makes dealers more competitive. The interaction between these effects determines whether a firm quote rule improves trading costs and price discovery. Our empirical results support the prediction that professional day traders prefer stocks with small spreads, but offer less support for the prediction that their trading leads to wider spreads.


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