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An analysis of brokers' trading with applications to order flow internalization and off-exchange sales

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  • Sugato Chakravarty
  • Asani Sarkar

Abstract

We study a variety of issues related to brokers' trading. In our model, multiple informed traders and noise traders trade through multiple brokers. Brokers may trade with their customers in the same transaction (simultaneous dual trading) or trade after their customers in a separate transaction (consecutive dual trading). With a fixed number of traders, and relative to consecutive dual trading, informed and noise traders are worse off, brokers are better off, and market depth is lower in the simultaneous dual trading market. When we endogenize the number of brokers, informed and noise traders choose one (all) broker(s) in the simultaneous (consecutive) dual trading market. If the entry cost is low, more informed traders enter the simultaneous dual trading market and market depth may be higher relative to consecutive dual trading. If the entry cost is high, consecutive dual trading is better. We study order flow internalization by broker-dealers, and show that, in the free entry equilibrium, internalization hurts retail customers and market quality; and that it is likely to be more prevalent in thin markets with few informed traders. Finally, we examine off-exchange block sales and find that, compared to exchange transactions, they are more liquid but less informative.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9813.

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Date of creation: 1998
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Handle: RePEc:fip:fednrp:9813

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Keywords: Stock market ; Prices;

References

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  1. Spiegel, Matthew & Subrahmanyam, Avanidhar, 1992. "Informed Speculation and Hedging in a Noncompetitive Securities Market," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(2), pages 307-29.
  2. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, American Economic Association, vol. 80(3), pages 465-79, June.
  3. Battalio, Robert H, 1997. " Third Market Broker-Dealers: Cost Competitors or Cream Skimmers?," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 341-52, March.
  4. Chang, Eric C. & Loche, Peter R., 1996. "The Performance and Market Impact of Dual Trading: CME Rule 552," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 5(1), pages 23-48, January.
  5. Roell, Ailsa, 1990. "Dual-capacity trading and the quality of the market," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 1(2), pages 105-124, June.
  6. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1996. " Cream-Skimming or Profit-Sharing? The Curious Role of Purchased Order Flow," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 811-33, July.
  7. Shiller, Robert J, 1995. "Conversation, Information, and Herd Behavior," American Economic Review, American Economic Association, American Economic Association, vol. 85(2), pages 181-85, May.
  8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
  9. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
  10. Sanford J. Grossman, . "An Economic Analysis of Dual Trading," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 33-89, Wharton School Rodney L. White Center for Financial Research.
  11. Shiller, Robert J, 1990. "Market Volatility and Investor Behavior," American Economic Review, American Economic Association, American Economic Association, vol. 80(2), pages 58-62, May.
  12. Macey, Jonathan R. & O'Hara, Maureen, 1997. "The Law and Economics of Best Execution," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 6(3), pages 188-223, July.
  13. Battalio, Robert & Greene, Jason & Jennings, Robert, 1997. "Do Competing Specialists and Preferencing Dealers Affect Market Quality?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(4), pages 969-93.
  14. Holden, Craig W & Subrahmanyam, Avanidhar, 1992. " Long-Lived Private Information and Imperfect Competition," Journal of Finance, American Finance Association, American Finance Association, vol. 47(1), pages 247-70, March.
  15. Fishman, Michael J & Longstaff, Francis A, 1992. " Dual Trading in Futures Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 47(2), pages 643-71, June.
  16. Sarkar Asani, 1995. "Dual Trading: Winners, Losers, and Market Impact," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 4(1), pages 77-93, January.
  17. Dutta, Prajit K & Madhavan, Ananth, 1997. " Competition and Collusion in Dealer Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 245-76, March.
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Cited by:
  1. Chakravarty, Sugato, 2001. "Stealth-trading: Which traders' trades move stock prices?," Journal of Financial Economics, Elsevier, Elsevier, vol. 61(2), pages 289-307, August.

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