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Insider Trading Equilibrium with a Strategic Market Maker

Article arXiv papers · Author: Knut Aase et al.
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Summary

This theoretical study modifies the continuous-time Kyle insider trading model by allowing the market maker to pursue profit rather than act as a fiduciary. The market maker has market power and uses information in order flow to set prices advantageously. The resulting equilibrium permits positive expected market-maker profits.

The analysis suggests that a modest fee tied to order flow can make the market maker’s profits comparable to, or greater than, those of a perfectly informed insider. It also offers a mechanism for speculative prices to be more volatile than fundamental values alone would predict. The document provides a model-based argument rather than empirical validation, and the short description does not specify the model’s assumptions or conditions in detail. Its conclusions therefore depend on the chosen equilibrium setup and should not be treated as direct evidence about actual trading venues.

Key ideas

  • The model allows a market maker to maximize profit instead of acting as a fiduciary.
  • Market power lets the market maker use order flow to set advantageous prices.
  • A modest order-flow-contingent fee can produce substantial expected market-maker profits.
  • The model links strategic pricing to speculative volatility beyond fundamentals.
  • The claims are theoretical and depend on the model’s assumptions.

Tags

Market makingMarket microstructureStatistics
Full text
# Strategic Insider Trading Equilibrium with a Non-fiduciary Market Maker


# Strategic Insider Trading Equilibrium with a Non-fiduciary Market Maker









The continuous-time version of Kyle's (1985) model is studied, in which market makers are not fiduciaries. They have some market power which they utilize to set the price to their advantage, resulting in positive expected profits. This has several implications for the equilibrium, the most important being that by setting a modest fee conditional of the order flow, the market maker is able to obtain a profit of the order of magnitude, and even better than, a perfectly informed insider. Our model also indicates why speculative prices are more volatile than predicted by fundamentals.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.