Strategic Insider Trading Equilibrium with a Non-fiduciary Market Maker

TL;DR

This paper extends Kyle's model to a setting where market makers are non-fiduciaries with market power, showing they can profit from order flow and explaining increased price volatility.

Contribution

It introduces a continuous-time Kyle model with non-fiduciary market makers who set prices strategically, revealing new profit mechanisms and volatility explanations.

Findings

Market makers can earn profits exceeding insider information.

Pricing strategies enable market makers to profit from order flow.

Speculative prices exhibit higher volatility than fundamental values.

Abstract

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.