What I like about these chapters is that they are instructive about market phenomena that are of particular concern in this time of rapid change of financial institutions. The studies provide theories of phenomena that have not been given a theoretical treatment before, and theories that can be put to immediate use in understanding the recent market innovations and their consequences. Moreover, there is some valuable empirical work that exploits the ‘controlled experiment’ offered by a recent institutional reform.

Front-running and stock market liquidity

The front-running study (Chapter 7) shows how the broker–dealer (i.e., dual-capacity dealer) will decide on the optimal amount of front-running to do, how the quantities are determined in a general equilibrium, and establishes a way to measure the consequences of front-running.

Pagano and Röell present two models of front-running, that show two fundamentally different reasons for the price response to demand that is essential to front-running. In the first model, price increases in response to demand increases because the demand increases are a noisy signal of fundamental value. In the second, price decreases in response to demand decreases because of the risk aversion of market makers, their unwillingness to hold more of the asset (to allow customers to hold less) unless its expected yield rises to compensate them for the greater risk in their portfolios. It would seem that their first model is preferable.