Kumar Venkataraman

Performance of Institutional Trading Desks: An Analysis of Persistence in Trading Costs

Using a proprietary dataset of institutional investors’ equity transactions, we document that institutional trading desks can sustain relative performance over adjacent periods. We find that trading-desk skill is positively correlated with the performance of the institution’s traded portfolio, suggesting that institutions that invest resources in developing execution abilities also invest in generating superior investment ideas. Although some brokers can deliver better executions consistently over time, our analysis suggests that trading-desk skill is not limited to a selection of better brokers. We conclude that the trade implementation process is economically important and can contribute to relative portfolio performance. ( JEL G12, G23, G24)

Earnings Quality and Information Asymmetry: Evidence from Trading Costs

The adverse consequences of poor earnings quality have been the subject of significant debate among academics, practitioners and regulators. However, the empirical evidence on pricing implications of earnings quality is sparse and controversial. We examine one potential consequence of poor earnings quality - its impact on information asymmetry. We document that poor earnings quality increases the adverse selection risk as manifested in trading costs and lowers liquidity in financial markets. Both innate and discretionary components of earnings quality contribute significantly to information asymmetry. Further, poor earnings quality exacerbates information asymmetry around earnings announcements, especially for firms where earnings represent the principal source of information for market participants, suggesting that poor quality earnings offers a greater information advantage to informed traders. An important implication is that earnings quality can affect cost of capital via its impact on trading cost. Additionally, from a policy perspective, we show that earnings quality can lead to significant variation in information asymmetry even for firms within a uniform reporting regime.

Trading Activity and Transaction Costs in Structured Credit Products

After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps. Structured credit products (SCPs), including asset-backed securities (ABSs) and mortgage-backed securities (MBSs), compose one of the largest (comparable in size to the US Treasury security market) but least studied segments of the financial services industry. SCPs are complex instruments that include the payment obligations of numerous borrowers, contain multiple tranches that differ in terms of payment priority in case of default, and have sizes that can change randomly as underlying loans are repaid. Uncertainty regarding SCP valuation played a role in the recent financial crisis, owing in part to the fact that secondary trades for SCPs occurred in an opaque dealer market without public quotes or trade reports. Since May 2011, FINRA has required broker/dealers to report transaction prices and quantities for SCP trades to the TRACE (Trade Reporting and Compliance Engine) system. However, FINRA does not yet disseminate data for most SCP transactions to the public. Effective 5 November 2012, the U.S. SEC approved the public dissemination of transaction prices in a subset of SCPs (specifically, in “to-be-announced” securities). FINRA has recently proposed that trade prices of SCPs, including MBSs and ABSs, be disseminated to the public. For investors as well as regulators, the key difficulty in an opaque market lies in establishing the prevailing market price. Investors cannot compare their own execution prices with those observed for other transactions. Even institutional investors have to invest significant time and effort to obtain market information, either via ‘‘indicative’’ quotes obtained through messaging systems or by telephone calls to dealers. Increased transparency has the potential to reduce dealer markups, provide information on the fair price of securities, and improve the ability to control and evaluate trade execution costs. In this study, we examined the accumulated FINRA data to provide what we believe is the first comprehensive description of this important but little-studied market. The data include all secondary market transactions for the universe of US SCPs from 16 May 2011 to 31 January 2013. We report on trading activity by subtypes of SCPs, the determinants of secondary market trading, and estimates of transaction costs in each type of SCP. Finally, focusing on segments of the corporate bond market that are comparable to segments of the SCP markets in terms of key characteristics, we present estimates of the potential effects of implementing transaction dissemination in these markets. Notably, less than 20% of the SCP universe traded at all during the 21-month sample period. One-way trade execution costs for SCPs averaged about 24 bps. However, trade execution costs varied substantially across SCP categories, from 92 bps for CBOs to just 1 bp for TBA securities. We show that trading costs depend in particular on what we term the product’s “customer profile,” which depends on issue size and the proportion of retail to institutional-size trades. Subproducts with an institutional profile tend to have lower costs. The highest average trading costs are observed for agency CMOs (74 bps) and CBOs (92 bps), each of which has a low (22% or less) proportion of large trades. The lowest average trading cost estimates are observed for TBA securities (1 bp), CMBSs (12 bps), and ABSs secured by auto loans and equipment (7 bps), each of which has a substantial (54% or greater) percentage of large trades. By matching SCP subtypes with corporate bonds that are comparable in terms of customer profile, we present rough estimates of the potential impact of introducing price transparency for the SCP markets. Our analysis indicates that price transparency is likely to be associated with substantial decreases of 5–7 bps in one-way trading costs for MBSs, agency CMOs, and CBO securities, as well as securities in the subgroups TRAN and WHLN. We anticipate smaller trading cost reductions of about 2 bps for private label CMOs. In contrast, we anticipate little or no change in trading costs for CMBSs and SBA securities, as well as ABSY issues and CDOs. Broadly speaking, this analysis indicates that trading cost reductions are most likely to be observed for SCPs with a retail clientele, whereas transaction dissemination is less likely to be relevant for those products with an institutional clientele, which already carry lower trading costs.After conducting the first study of secondary trading in structured credit products, the authors report that the majority of products did not trade even once during the 21-month sample. Execution costs averaged 24 bps when trades occurred and were considerably higher for products with a greater proportion of retail-size trades. The authors estimate that the introduction of public trade reporting would decrease trading costs in retail-oriented products by 5–7 bps.

Informed Trading and Price Discovery before Corporate Events

Stock prices incorporate less news before negative events than positive events. Further, informed agents use less price aggressive (limit) orders before negative events and more price aggressive (market) orders before positive events (buy–sell asymmetry). Motivated by these patterns, we model the execution risk that informed agents impose on each other and relate the asymmetry to costly short selling. When investor base is narrow, security borrowing is difficult, or the magnitude of the event is small, buy–sell asymmetry is pronounced and price discovery before negative events is lower. Overall, we show that the strategies of informed traders influence the process of price formation in financial markets, as predicted by theory.

Evidence-Based Regulatory Policy Making for Financial Markets: A Panel Discussion of a Proposed Framework for Assessing Market Quality

Senior practitioners, regulators, and academics discuss a proposed framework for assessing security market quality. Three metrics of market integrity and two metrics of market efficiency are presented for European, Asian, and North American exchanges.

Capital Commitment and Illiquidity in Corporate Bonds

We study trading costs and dealer behavior in U.S. corporate bond markets from 2006 to 2016. Despite a temporary spike during the financial crisis, average trade execution costs have not increased notably over time. However, dealer capital commitment, turnover, block trade frequency, and average trade size decreased during the financial crisis and thereafter. These declines are attributable to bank‐affiliated dealers, as nonbank dealers have increased their market commitment. Our evidence indicates that liquidity provision in the corporate bond markets is evolving away from the commitment of bank‐affiliated dealer capital to absorb customer imbalances, and that postcrisis banking regulations likely contribute.