The optimal bid/ask spread in a Specialist System

In this work we propose a simple market model where some features of the Specialist System are analyzed. In particular, the specialist's obligation to display bid/ask quotes on the book within the bounds imposed by the Exchange is considered. The proposed model allows to analyze the effects of the specialist's interventions on the short term dynamics of bid/ask prices and address a relevant market design issue, that is determination and analysis of the optimal endogenous upper bound that - according to economic conditions - should be imposed by Stock Exchange on the quoted bid/ask spread. The institutional details are summarized in a few structural parameters and the focus is on the aggregate effects of excess demand/supply.

Research highlights► Theoretical model describing specialist's intervention in financial markets. ► Endogenization of the process describing the dynamics of the bid/ask spread and maximum allowed spread. ► Market design implications related to the setting of the optimal maximum allowed spread.