This paper uses a unique dataset of audit trail transactions to examine the trading behavior of market makers in the Treasury bond futures market when Long-Term Capital Management (LTCM) faced binding margin constraints in 1998. Although identities are concealed in the dataset, I find strong evidence that during the crisis market makers in the aggregate engaged in front running against customer orders from a particular clearing firm (coded "PI7") that closely match various features of LTCM's trades through Bear Stearns. That is, market makers traded on their own accounts in the same direction as PI7 customers did, but one or two minutes beforehand. Furthermore, a significant percentage of market makers made abnormal profits on most of the trading days during the crisis. Their aggregate abnormal profits, however, were more than offset by abnormal losses realized after the private sector recapitalization of LTCM. Moreover, I show that before the rescue, a market maker's cumulative abnormal profit was positively correlated both to her tie as contra party with PI7 and to the intensity of her front running, but these relationships turned negative after the rescue. The overall evidence suggests that the recapitalization plan effectively relaxed LTCM's binding constraints and therefore reversed the profitability of front running.
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Markus K. Brunnermeier & Lasse Heje Pedersen, 2005.
"Predatory Trading,"
Journal of Finance,
American Finance Association, vol. 60(4), pages 1825-1863, 08.
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Markus K. Brunnermeier & Lasse Heje Pedersen, 2004.
"Predatory Trading,"
NBER Working Papers
10755, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Markus K Brunnermeier & Lasse Heje Pederson, 2003.
"Predatory Trading,"
FMG Discussion Papers
dp441, Financial Markets Group.
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Brunnermeier, Markus K & Pedersen, Lasse Heje, 2004.
"Predatory Trading,"
CEPR Discussion Papers
4639, C.E.P.R. Discussion Papers.
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H. Henry Cao & Richard K. Lyons & Martin D.D. Evans, 2003.
"Inventory Information,"
NBER Working Papers
9893, National Bureau of Economic Research, Inc.
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Other versions:
H. Henry Cao & Martin D. Evans & Richard K. Lyons, 2006.
"Inventory Information,"
Journal of Business,
University of Chicago Press, vol. 79(1), pages 325-364, January.
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