New Developments in Long-Term Asset Management
Monika Piazzesi and Luis Viceira, Organizers
Second Annual Conference
New York, New York
May 19-20, 2017
The Relevance of Broker Networks
Institutional investors routinely make use of brokers to execute their trades. Despite the rise of electronic trading, the Tabb Group reports that brokers handle about 42 percent of order flow from hedge funds. However, brokers' roles in disseminating information that they acquire from clients is at best unclear. Although information about prices is readily disseminated in equity markets, brokers' vantage points might allow them to extrapolate the informational content of an order and to anticipate the future behavior of prices. For example, they can condition on the identity of the trader and are aware of the order flow before it hits the market. In these cases, brokers might have an incentive to extract these informational rents by communicating and spreading the information to their clients.
Other Conference Papers
Institutional Investors and Information Acquisition, Matthijs Breugem and Adrian Buss
Both brokers' practice of selling order flow and regulatory scrutiny of potential information leakage provide anecdotal evidence for the conjecture that brokers play a pivotal role in directing information flow in the market. Marco Di Maggio of Harvard Business School, Francesco Franzoni and Carlo Sommavilla of the Università della Svizzera italiana at Lugano, and Amir Kermani of the University of California, Berkeley, analyze a comprehensive trade-level dataset from 1999 to 2014 that contains the identities of both brokers and asset managers to show that brokers who execute trades on behalf of informed investors may extract the informational content of the orders and spread it to their other clients.
The researchers provide evidence of this information leakage through three main tests. First, if brokers disseminate the information contained in informed trades, other investors should behave similarly to the informed ones. Evidence consistent with this hypothesis is gathered by investigating large trades executed by hedge funds (originators) that are profitable and anticipate a move of asset prices that is not followed by a reversal even after several months. This test finds that other investors (followers) are significantly more likely to trade with the same broker in the same direction of the large informed trade, while the broker is still executing the originator's order.
Second, if brokers have access to superior information, they should release it selectively and in a way which allows them to extract the highest rents. Based on this logic, the researchers show that brokers' best clients — those with whom the broker made more profits in the past and from whom it expects to continue to receive business in the future — receive the information about other investors' trades. The researchers restrict attention to block trades where the originator has institutional ties with the broker and find that, in this case, the broker preempts competition from other traders.