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Intermediary Trading, Trading Venues, and Market Liquidity

Paper Session

Saturday, Jan. 4, 2020 2:30 PM - 4:30 PM (PDT)

Manchester Grand Hyatt, Seaport G
Hosted By: American Finance Association
  • Chair: Yajun Wang, City University of New York-Baruch College

Large Orders in Small Markets: On Optimal Execution with Endogenous Liquidity Supply

Agostino Capponi
,
Columbia University
Albert Menkveld
,
VU University Amsterdam
Hongzhong Zhang
,
Columbia University

Abstract

Increased intermediation made some investors "too large" for their markets. If such investor needs to sell quickly, then he cannot reach buyers who arrive later. Market makers then supply liquidity by taking on inventory to sell to future buyers. We solve a Stackelberg game where a large uninformed seller executes optimally, fully cognizant of the response of Cournot-competitive market makers. The game therefore endogenizes both demand and supply of liquidity. The closed-form solution yields several insights. First, stealth trading is both privately and socially costly because market makers incur additional cost not knowing when execution ends. Second, the presence of a large seller does not unambiguously benefit other participants. Market makers benefit only if there is enough risk-absorption capacity or if the execution period is short. Other investors benefit only when the seller sells at high enough intensity. Under sunshine trading where market makers know when execution ends price pressure might subside before execution ends rationalizing such pattern observed in the data. Our normative results have direct implications on institutional investors: it allows them to determine how much they are able to trade in a "small market" within a particular time frame, and to assess the dependence of the implied optimal trade intensity on market conditions, such as the rate of investor arrivals, the demand elasticity of these investors, the number of market makers, and funding costs.

From Market Making to Matchmaking: Does Banking Regulation Harm Market Liquidity?

Gideon Saar
,
Cornell University
Jian Sun
,
Massachusetts Institute of Technology
Ron Yang
,
Harvard University
Haoxiang Zhu
,
Massachusetts Institute of Technology and NBER

Abstract

Post-crisis bank regulations raised the market-making costs of bank-affiliated dealers. We show that this can, somewhat surprisingly, improve the overall welfare of investors and reduce average transaction costs, despite the increased cost of immediacy. Bank dealers in OTC markets optimize between two parallel trading mechanisms: market making and matchmaking. Bank regulations that increase market-making costs intensify competitive pressure from non-bank dealers and incentivize bank dealers to invest in technology that shifts their business toward matchmaking. Thus, post-crisis bank regulations have the (unintended) benefit of replacing the costly balance sheet of banks with a more efficient form of financial intermediation.

Why Trade Over-the-Counter? When Investors Want Price Discrimination

Chaojun Wang
,
University of Pennsylvania
Tomy Lee
,
University of Toronto

Abstract

Despite the availability of low-cost exchanges, over-the-counter (OTC) trading is pervasive for most assets. We explain the prevalence of OTC trading using a model of adverse selection, in which informed and uninformed investors choose to trade over-the-counter or on an exchange. OTC dealers' ability to price discriminate allows them to imperfectly cream-skim the uninformed investors from the exchange. Assets with wider bid-ask spreads on exchanges are predicted to have a higher proportion of total volume that is traded on exchanges, as supported by evidence from US stocks. Having an OTC market can reduce welfare while increasing total trade volume and decreasing average bid-ask spread. Specifically, for assets that are mostly traded over-the-counter (such as swaps and bonds), having the OTC market actually harms welfare. Our results justify recent policies that seek to end OTC trading for such assets.
Discussant(s)
Kerry Back
,
Rice University
Albert Kyle
,
University of Maryland
Cecilia Parlatore
,
New York University
JEL Classifications
  • G1 - General Financial Markets