Insider Trading, Liquidity, and the Role of the Monopolist Specialist

TLDR

Trading on private information creates inefficiencies due to suboptimal risk sharing, but the monopolist specialist can mitigate this by enhancing market liquidity. Marketmakers lower liquidity in response to private information, whereas a monopolist averages profits across trades, affecting liquidity dynamics. The model predicts higher liquidity when private information trading is extensive. © 1989 University of Chicago.

Abstract

Trading on private information creates inefficiencies because there is less than optimal risk sharing. This occurs because the response of marketmakers to the existence of traders with private information is to reduce the liquidity of the market. The institution of the monopolist specialist may ease this inefficiency somewhat by increasing the liquidity of the market. While competing marketmakers will expect a zero profit on every trade, the monopolist will average his profits across trades. This implies a more liquid market when there is extensive trading on private information. Copyright 1989 by the University of Chicago.