Intermediaries’ Advantage Based on Skill, Not Privileged Information

Newswise — The conventional view of intermediaries in financial markets is relatively simplistic " they execute orders on behalf of their clients. However, the role of intermediaries has received increased scrutiny due to another facet of their trading " that for their own proprietary accounts. A significant but unresolved question about this role is whether these intermediaries are passive traders or whether they actively seek and trade on information.

This question gained prominence post-decimalization in the markets, when many critics accused the New York Stock Exchange (NYSE) specialists of having an advantage by being on the trading floor. Critics charged that specialists used their privileged view of trading activity on the floor to gain an upper hand in trading.

A new study by Amber Anand, associate professor of finance in the Whitman School of Management, and Avanidhar Subrahmanyam, Professor of Finance at UCLA, seeks to examine the role of intermediaries in a market where intermediaries are not on the trading floor. The Toronto Stock Exchange (TSE) was the first North American exchange to replace fractional pricing with decimal pricing in 1996, and it was one of the first major exchanges to fully adopt electronic trading in 1997, abandoning its trading floor for a fully computerized system. The TSE was the perfect fit for the author's research.

"We chose the TSE because it is completely electronic and has been for a number of years," says Anand. "We wanted to study an exchange where intermediaries have largely the same information set as the rest of the world in order to determine if intermediaries still have an advantage."

Anand continues, "Our results clearly show that intermediaries tend to be more informed than other traders in the market. The question is what is the source of this information?"

Anand's research, published in 2008 in the Journal of Financial and Quantitative Analysis, and co-authored with Avanidhar Subrahmanyam, the Goldyne and Irwin Hearsh Chair in Money and Banking at the UCLA Anderson Graduate School of Management, shows that skills in forecasting, experience at trading, and well-honed intuition may play a role in intermediary advantage, separate from any advantages that accrue from access to the trading floor.

"Ultimately, we found that making a market electronic will not eliminate the advantage of intermediaries," says Anand.

The research findings do indicate that the advantages are short-term, however. Anand elaborates: "Traders who are skilled at exploiting information in the short-term can perform better. We found no evidence to suggest they are exploiting their clients, however. Instead, it is their skills at being intermediaries that give them a greater comparative advantage, especially in stocks with less competition for information."

These findings indicate that a transition from a floor to a screen-based trading system would not make intermediaries irrelevant. On the contrary, because intermediaries tend to be more informed, they have an advantage even in a transparent electronic market.

Anand's current research focuses on investigating the importance of designated market makers in electronic markets, and the role of geography in market making.