We analyze trading speed and fragmentation in asset markets. Trading venues make technological investments and compete for investors who choose where and how much to trade. Faster venues charge higher fees and attract speed-sensitive investors. Competition among venues increases investor participation, trading volumes, and allocative efficiency but entry and fragmentation can be excessive, and speeds are inefficient. Regulations that protect transaction prices (e.g., Securities and Exchange Commission trade-through rule) lead to greater fragmentation and faster speeds but may reduce allocative efficiency. Our model sheds light on the experience of European and U.S. markets since the implementation of Markets in Financial Instruments Directive and Regulation National Markets System.
Do market-based signals reveal the trading of privately informed investors? We examine this question using a novel sample of over 5,000 equity and option trades based on material and non- public information documented in the insider trading litigation files of the U.S. Securities and Exchange Commission (SEC). Our results have three main implications: (1) Trades based on private information about the value of the underlying asset do have an impact on the behavior of information signals. (2) The relation between private and public signals is complex and, in several cases, including commonly used liquidity metrics, contrary to standard theories. Days when informed investors trade display abnormally high volatility and volume and low illiquidity in both stock and option markets, especially for small stocks. (3) Trade volume is more informative in option markets than in stock markets. The most consistent signals combine both option and stock volume, especially the volume of leveraged and short-term options. We find that the ability of the signals to detect private information is weaker when experienced traders or top executives trade. We exploit the implementation of the SEC’s Whistleblower Reward Program to validate our results with regard to potential selection concerns. Overall, our results provide new guidance in the search for private information.
With Albert Menkveld and Marius Zoican, R&R requested by The Journal of Financial Economics). Paper
We investigate the effects of introducing a central clearing counterparty (CCP) on price volatility by adopting as an experimental construct the 2009 clearing reform in three Nordic markets. A key feature of this event is that the transition from bilateral to central clearing was mandatory for all market participants. We find that, relative to similar European stocks, price volatility in these Nordic equities experience an economically significant decline of 8.8% relative to pre-reform levels. The decrease in volatility is more pronounced for stocks with higher margin cost impact, consistent with the predictions of recent dynamic asset pricing models. We also find that the reform induces a sharp decline of 11% in trade volume, but no deterioration of market quality as captured by measures of trading costs and price informativeness. Overall, our results highlight that the adoption of central clearing enhances price stability. Our results also suggest that there is an important coordination role for policy as, when given the option, investors failed to voluntarily clear trades in the CCP.
We study the consequences of trading fragmentation and speed on liquidity and asset prices. Trading venues invest in speed-enhancing technologies and price trading services to attract investors. Investors trade due to preference shocks. We show how the resulting market organization affects asset liquidity and the composition of par- ticipating investors. In a consolidated market, speed investments raise liquidity and prices. When markets fragment, liquidity and asset prices can move in opposite directions. We also show how mechanisms that protect execution prices, such as the SEC’s trade-through rule, can decrease price levels and trading volume relative to unregulated markets. Our results suggest that recent regulatory reforms in secondary markets may have unintended negative consequences for public corporations.
This paper studies an asset market where, as in major world exchanges, informed and liquidity investors continuously control the timing of orders and whether to take or provide liquidity. In equilibrium, investors demand and supply liquidity simultaneously, following distinctive time-varying patterns previously found in experiments. The resulting linkages between prices, order frequency and depths shed light on empirical regularities. By nesting limit-order and dealer markets, I find that the speed of information transmission is higher in the former and increases with investor sophistication. Evidence from proprietary NYSE data provides support for the implied liquidity provision behavior of investors.
(With Marcin Kacperczyk, July 2017)
How do traders trade on superior information on firms’ fundamentals? Despite the breadth of the theoretical literature analyzing this issue, direct evidence on their behavior is scarce as private information sets are almost never observable. We address this identification challenge by utilizing a unique hand-collected sample of insider trading cases prosecuted by the U.S. Securities Exchange Commission (SEC) documenting how individuals and firms trade on nonpublic and material information. We find evidence that informed traders strategically time when to trade after receiving tips on fundamentals. Personal characteristics and the content of the private signals play a key role in how informed traders split their trades and managing trade size.