A standard presumption of market microstructure models is that competition between risk-neutral market makers inevitably leads to price schedules that leave market makers zero expected profits conditional on the order flow. This article documents an important lack of robustness of this zero-profit result. In particular, we show that if traders can split orders between market makers, then market makers set less-competitive price schedules that earn them strictly positive profits and hence raise trading costs. Thus, this article can explain why somebody might willingly make a market for a stock when there are fixed costs to doing so. The analysis extends to a limit order book, which by its nature is split against incoming market orders: equilibrium limit order schedules necessarily yield those agents positive expected profits.

A standard presumption of market microstructure models is that competition between risk-neutral market makers inevitably leads to price schedules that leave market makers zero expected profits conditional on the order flow. This article documents an important lack of robustness of this zero-profit result. In particular, we show that if traders can split orders between market makers, then market makers set less-competitive price schedules that earn them strictly positive profits and hence raise trading costs. Thus, this article can explain why somebody might willingly make a market for a stock when there are fixed costs to doing so. The analysis extends to a limit order book, which by its nature is split against incoming market orders: equilibrium limit order schedules necessarily yield those agents positive expected profits.

We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.

[We study insider trading in a dynamic setting. Rational, but uninformed, traders choose between investment projects with different levels of insider trading. Insider trading distorts investment toward assets with less private information. However, when investment is sufficiently information elastic, insider trading can be welfare-enhancing because of more informative prices. When insiders repeatedly receive information, they trade to reveal it when investment is information elastic because good news increases investment and hence future insider profits. Thus, more information is revealed and uninformed agents are exploited less frequently by insiders. Both effects are Pareto-improving. Finally, we consider various insider-trading regulations.]

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence, price improvement and trade size should be negatively correlated in a dealer market. We confirm our model's predictions using unique data from the London Stock Exchange during 1991.

We argue that competition between dealers in a classic dealer market is intertemporal: A trader identifies a particular dealer and negotiates a final price with only the intertemporal threat to switch dealers imposing pricing discipline on the dealer. In this kind of market structure, we show that dealers will offer greater price improvement to more regular customers, and, in turn, these customers optimally choose to submit larger orders. Hence, price improvement and trade size should be negatively correlated in a dealer market. We confirm our model's predictions using unique data from the London Stock Exchange during 1991.

Dramatic microstructure changes in equity markets have made standard liquidity measures less accurate proxies for trading costs. We develop trade-time liquidity measures that reflect per-dollar price impacts of fixed-dollar volumes. Our measures better capture institutional trading costs and better explain the cross-section of returns than do standard measures, especially in recent years. Despite improvements in measures of market quality, expected trading costs have explanatory power for the cross-section of expected returns: we obtain monthly liquidity premium estimates of 5.3 bp for expected returns and 2.4 bp for risk-adjusted returns. Estimated premiums rise after the financial crisis and remain high thereafter.