We analyze trading speed and fragmentation in asset markets. In our model, 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 volume, and allocative efficiency, but entry and fragmentation can be excessive, and speeds are generically inefficient. Regulations that protect transaction prices (e.g., Securities and Exchange Commission trade-through rule) lead to greater fragmentation. 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.
(with Marcin Kacperczyk). The Review of Financial Studies, Volume 32, December 2019. WFA 2016, 2017 NBER LTAM, 2017 NBER Asset Pricing SI, FIRS 2017. Paper.
Using over 5000 equity and option trades unequivocally based on nonpublic information about firm fundamentals, we find that commonly used asymmetric information proxies (AIPs) display abnormal values on days with informed trading. Volatility and trading volume are abnormally high, whereas illiquidity is low, both in equity and option markets. Daily returns reflect the sign of private signals but, on average, bid–ask spreads are 10% and 20% lower when informed investors are present in stock and option markets. Market makers’ learning under event uncertainty and the use of limit orders by informed investors help explain these findings. We characterize cross-sectional responses based on the duration of private information and find that informed traders select days with high uninformed volume to trade. Evidence from the U.S. Securities and Exchange Commission (SEC) Whistleblower Reward Program and the Financial Industry Regulatory Authority (FINRA) involvement address potential selection concerns.
Winner of the Best Cryptoeconomics Paper Award at the 2nd Toronto Fintech Conference. Resubmitted to The Review of Financial Studies. 2020 AEA, 2020 WFA, 2019 FIRS, 2019 EFA. Paper
We address the determination and evolution of bitcoin prices in a decentralized monetary economy. Users forecast the transactional and resale value of bitcoin holdings and price the risk of a malicious system attack. Miners contribute resources that enhance protection against attackers and compete for mining rewards. We show that Bitcoin’s security design leads to multiple equilibria: the same technology and fundamentals are consistent with sharply different price and security levels. Bitcoin’s deterministic monetary policy can lead to welfare losses and deviations from the quantity theory. The outcomes demonstrate how price–security feedback effects in open blockchains can amplify the volatility impact of fundamental shocks, and also lead to boom-bust cycles not driven by any fundamentals.
(with Marcin Kacperczyk). R&R requested by The Journal of Finance. 2020 AFA, 2020 LSE-Chicago U. Economics of Crime, 2020 UNC Asset Pricing, 2019 SFS Cavalcade. 2018 NBER Summer Institute, 2018 EFA. Paper.
How do illegal insider traders act on private information? Do they internalize legal risks? We address these questions using a unique sample of illegal insider traders convicted by the Securities Exchange Commission (SEC). To shed light on the traders’ investment strategies, we analyze, theoretically and empirically, the tradeoff between the risk of information becoming public (information risk) and the risk of being subject to enforcement actions (legal risk). Consistent with Kyle (1985), insiders manage their trades’ size and timing according to prevailing liquidity conditions, fundamental and noise volatility, and the value of the private tips they receive. Behavioral variables, such as gender, age, and profession, play a lesser role. Using various shocks to legal risk, we find that insiders internalize such risk by moderating trade aggressiveness, providing empirical support to the regulators’ actions. Consistent with Becker (1968), positive shocks to legal risk also induce insiders to concentrate on fewer private signals of higher economic value. Thus, insider trading enforcement could hamper stock price informativeness.
(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 Andrea Buraschi). 2019 AFA, 2018 NBER Asset Pricing Summer Institute, 2018 Finance Theory Group, London. #1 SSRN paper April 2018. Permanent WP. Paper
We address the valuation of bitcoins and other blockchain tokens in a new type of production economy: a decentralized financial network (DN). An identifying property of these assets is that contributors to the network trust (miners) are compensated in units of the same asset that are used by consumers of network applications, which we call unity. As a result, the overall production (hashrate) that affect network trust and the bitcoin price are jointly determined. We characterize the demand for bitcoins and the supply of resources that secure the network and show that the valuation of bitcoins can be obtained by solving a fixed-point problem and study its determinants. We show that the unity property induces “price-hashrate spirals” that amplify the price impact of demand and supply shocks vis-à-vis traditional assets.