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

SOES bandits are investors who use Nasdaq’s Small Order Execution System (SOES) for day trading. We develop a model of market making with costly information monitoring and examine the impact of SOES bandits on spreads and price discovery. Costly monitoring hampers price competition since dealers can share the monitoring costs and earn prots by matching rather than undercutting their competitors’ quotes. Bandits tend to counteract this eect and add competitive pressure. The interaction between these eects determines whether a policy that relaxes the rm quote rule improves spreads, price discovery, and liquidity. We report empirical evidence consistent with the prediction that bandits prefer to trade stocks with small spreads, but only weak evidence supporting the prediction that trading by the bandits lead to wider spreads. (School of Management, Princeton University, Wharton School, University of Pennsylvania, CEPR)