Welfare Costs of Informed Trade
AFA 2016 San Francisco Meetings
46 Pages Posted: 23 Aug 2016 Last revised: 2 Jan 2020
Date Written: November 5, 2019
We examine the welfare costs of informed trade in a new sequential trade model with elastic uninformed traders. Welfare losses occur when the liquidity costs of executing a trade exceed the potential gains from the trade. With long-lived private information, more informed traders lead to better liquidity and less welfare losses because the benefits of faster price discovery outweigh the costs of wider initial spreads. For short-lived information, this tradeoff does not materialize and welfare losses increase with the amount of informed trade. Our findings suggest that regulation of informed trade should consider the horizon of private information.
Keywords: market microstructure, welfare, liquidity, informed trading, insider trading
JEL Classification: G14, K22
Suggested Citation: Suggested Citation