Strategic Specialist and Market Liquidity

Abstract

The empirical literature suggests that the limit order book contains information that might be used by the specialist for his own advantage. We develop a model of insider trading where there is a specialist who has access to the order book and informed traders who receive information about the liquidation value of the asset. The presence of a strategic specialist in the market induces non-monotonicity of market indicators with respect to the variance of liquidation value. Moreover, the existence of private information about supply significantly affects market performance as it induces, among other effects, lower market liquidity. Finally, our model suggests another link between Kyle's (1985, 1989) and Glosten and Milgrom's (1985) models by allowing for strategic behavior of the specialist.