37 J.L. & Econ. 215 (1994)
Assessing the Costs of Regulation: The Case of Dual Trading

handle is hein.journals/jlecono37 and id is 219 raw text is: ASSESSING THE COSTS OF REGULATION:
THE CASE OF DUAL TRADING*
TOM SMITH and ROBERT E. WHALEY
Duke University
THE practice of dual trading in futures exchanges across the United
States has existed since the advent of organized futures markets in the
mid-1800s. Under a dual trader market-making system, market makers
are permitted to execute transactions for customers and on personal ac-
count. With two sources of income to cover the costs of operation-
brokerage commissions and dealer/speculator profits-dual trader mar-
kets have greater numbers of market makers than otherwise comparable
markets that permit traders to earn income from only brokerage or deal-
ing/speculation. With more market makers, the level of competition for
providing the market-making service is increased, thereby increasing
market liquidity and lowering the costs of trading (that is, brokerage
commissions and the bid/ask spread).'
Dual trading prevails on security and futures exchanges in the United
States as well as in other countries. Grossman provides a comprehensive
list of dual trader markets worldwide.2 In futures markets, a substantial
proportion of total trading volume is executed by dual traders. The Coin-
* We thank Todd Petzel at the Chicago Mercantile Exchange for providing us with
information regarding the top-step rule in the S&P 500 index futures pit. Margaret Monroe
provided extremely useful and insightful comments on an earlier draft of this paper. Com-
ments and suggestions by Steven Figlewski, F. Douglas Foster, Hans R. Stoll, Joseph R.
Sweeney, an anonymous referee, and the seminar participants at Duke University, Indiana
University, Southern Methodist University, the University of Oklahoma, the 1990 Northern
Finance Association meetings in Banff, Alberta, and the 1992 Western Finance Association
meetings in San Francisco are also gratefully acknowledged. Research support was received
from the Business Associates' Fund (Smith) and the Isle Maligne Fund (Whaley).
' Other arguments in support of dual trader markets have also been suggested. Some
argue that dual traders operate more efficiently than do exclusive brokers because their
own money is at risk. Others argue that dual traders can provide lower transaction costs
because they are better informed about the market and/or have superior trading skills as a
result of handling both personal and customer orders.
2 Sanford J. Grossman, An Economic Analysis of Dual Trading 62-72 (working paper,
University of Pennsylvania, Wharton School, Rodney L. White Center for Financial Re-
search, 1989).
[Journal of Law and Economics, vol. XXXVII (April 1994)]
C 1994 by The University of Chicago. All rights reserved. 0022-2186/94/3701-0009$01.50

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