Adverse Selection and Competitive Market Making: Empirical Evidence from a Limit Order Market

This article presents a new methodology for testing economicrestrictions on the price schedules offered in a limit orderbook that are based on (i) break-even conditions for marginallimit orders and (ii) rational updating conditions for orderbook revisions over time. Using order flow data from the StockholmStock Exchange, I find strong evidence of insufficient depthin the limit order books relative to the theoretical predictions.An extended model, which allows the model parameters to dependon market conditions, captures some of the systematic variationin the observed order book depth.     

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

This article presents a model of information monitoring andmarket making in a dealership market. We model how intensivelydealers monitor public information to avoid being picked offby professional day traders when monitoring is costly. Pricecompetition among dealers is hampered by their incentives toshare monitoring costs. The risk of being picked off by theday traders makes dealers more competitive. The interactionbetween these effects determines whether a firm quote rule improvestrading costs and price discovery. Our empirical results supportthe prediction that professional day traders prefer stocks withsmall spreads, but offer less support for the prediction thattheir trading leads to wider spreads.