Insider Trading, Liquidity, and the Role of the Monopolist Specialist

Trading on private information creates inefficiencies because there is less than optimal risk sharing. This occurs because the response of market makers to the existence of traders with private information is to reduce the liquidity of the market. The institution of the monopolist specialist may ease this inefficiency somewhat by increasing the liquidity of the market. While competing market makers will expect a zero profit on every trade, the monopolist will average his profits across trades. This implies a more liquid market when there is extensive trading on private information.