Trading Strategies and Information Flow Around Price Benchmarks

Abstract

This paper characterize equilibrium pricing and trading strategies in a competitive market where a subset of liquidity traders have a preference for executing their trades at a benchmark price. In the model, order flow is at a maximum while price impact is at a minimum when the price benchmark is set. These results are consistent with recent empirical evidence from foreign exchange markets.

The market structure in the model give incentives for the use of manipulative frontrunning strategies, but I show that the presence of a rational market maker partly negates the use of such strategies.This has important implications for benchmark design and understanding benchmark manipulation.

Keywords: Benchmarks, price impact, trading strategies, equilibrium

JEL Classification: G14, G12