The Role of Trading Halts in Monitoring a Specialist Market

Abstract

We model an exchange as a collection of specialists, each a monopolist market maker in a subset of the stocks listed on the exchange. Specialists can obtain net private benefits at the expense of the exchange (the collection of all specialists) by quoting a privately optimal pricing schedule. Conversely, a coordinated pricing schedule makes all specialists and customers better off. However, coordination requires a system of monitoring and punishment, which can break down when information asymmetries between the exchange and a specialist are high. This breakdown can cause the specialist to seek a temporary halt to trading to alleviate unjustified punishment, or the exchange to halt trading to prevent the quoting of damaging privately optimal pricing schedules. We use a sample of NYSE halts and a proxy for the exchange-specialist information asymmetry to test this theory. As predicted, we find a significant increase in estimated information asymmetry immediately preceding trading halts.

Keywords: Agency theory, market microstructure, trading costs, exchange organization

JEL Classification: G10