Information and the Intermediary: Are Market Intermediaries Informed Traders in Electronic Markets?

Abstract

Given the lack of any clear evidence on the informational contributions of market intermediaries vis-à-vis their clients in the extant literature, an important but unanswered question is whether intermediaries behave as passive traders or whether they actively seek and trade on information. In this paper, we explicitly compare the informational advantages of intermediaries with those of other investors in the market. We also analyze whether intermediaries trade ahead of their clients to buttress their profits. Using confidential trades data from the Toronto Stock Exchange, we find that intermediaries account for greater price discovery than other institutional and individual investors, in spite of initiating fewer trades and volume. Our estimates of price discovery attributable to market intermediaries range between 55% and 62%, although these traders are responsible for only 37% of trades, representing less than 41% of total volume. Our analysis indicates that the informational advantage of intermediaries is greater in stocks with low analyst following (and hence less competition for information). This advantage does not appear to stem from inappropriate handling of customer orders by intermediaries, such as frontrunning or stepping ahead of their clients.

Keywords: Price discovery, intermediaries

JEL Classification: G20