The effects of transaction costs on depth and spread*

This paper develops a model of depth and spread setting by a monopolistic dealer under asymmetric information to investigate the effect of imposing a transaction cost on the dealer’s quotes. Increasing the transaction cost affects the depth and the spread non-linearly. Under some distributional assumptions, when market conditions are favourable to the dealer, the spread responds less than proportionally to an increase in the transaction cost while the depth actually increases. In contrast, when market conditions are unfavourable to the dealer, the spread widens more than proportionally and the depth decreases, potentially to zero, in response to an increase in the transaction cost. * I thank Vincent Reinhart for helpful discussions. This paper is an extension of my paper “market making, prices, and quantity limits” to which the reader is referred for more details. The views expressed herein are the author’s and do not necessarily reflect those of the Board of Governors or the Federal Reserve System.