Final Report Summary - TAP (Trading and post-trading)
The ERC project “Trading and Post-trading” studied different parts of the trading process, including the determination of the transaction price and trading volume (trading), the behaviour of financial managers implementing the trading and post-trading process (managing), and the clearing and settlement of trades (post-trading).
Trading
We studied the consequences for asset pricing and transaction volume of limited information collection and processing abilities. These imperfections generate allocative inefficiencies but not necessarily lower equilibrium prices. They also cause changes in preferences, leading to round trip transaction and excess trading volume.
We also studied high-frequency trading. High-speed market connections and information processing improve financial institutions' ability to identify and seize trading opportunities, which raises gains from trade. However, the same technological advances enable fast traders to process information and act upon it before slow traders, which generates adverse selection. In this context, investment waves arise, in which institutions invest in fast-trading technologies just to keep up with the others. When some traders become fast, it increases adverse selection costs for all, i.e. it generates negative externalities. Because of these externalities, equilibrium investment can exceed its welfare-maximizing counterpart. Pigovian taxes on investment in high-frequency trading technology can restore optimality.
We also studied whether human beings with limited cognition can reach the optimal risk-sharing and equilibrium price predicted by theory. To do so, we designed an experiment that closely emulates and tests the standard model of complete competitive markets, without imposing parametric restrictions on preferences. Consistent with theory, aggregated elicited supply and demand curves cross at the expected dividend when there is no aggregate risk, and at a lower price when there is aggregate risk. In contradiction with theory, individual participants frequently make first order stochastically dominated choices. We propose a random choice model, consistent with the above-mentioned findings, and with the finding that large mistakes are less frequent than smaller ones.
Finally, we studied whether there is something special about bond making it necessary to trade in fragmented markets and impossible to trade in transparent limit-order markets. We collected and analysed historical data showing that before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as trading migrated to the fragmented over-the-counter market. Average trading costs in municipal bonds on the NYSE were half as large in 1926-1927 as they are today in the fragmented over the counter market. Trading costs in corporate bonds for small investors in the 1940s were as low or lower than they are now. The difference in transactions costs likely reflects the differences in market structures, since underlying technological changes have likely reduced costs of matching buyers and sellers.
Managing
We studied how managers choose to adopt financial innovations, and how they choose more or less complex investment tasks. We allow for the possibility that financial managers be opportunistic and adopt innovations of choose complex tasks not because this is in the interest of the final investors, but because this can increase their own rents. These rents are agency rents, arising because of information asymmetries.
The combination of moral hazard and adverse selection amplify the boom and bust patterns associated with financial innovations and worsen risk--prevention. Thus, they generate excessively large and costly crises.
Complex tasks give rise to agency rents, and, for that reason, financial managers choose excessively complex tasks. In our overlapping generations model, there is competition between successive generations of managers. Old managers are an imperfect substitute for young ones, because the long horizons of young managers make them easier to incentivize, other things equal, than old managers with short horizons. This limits the competitive pressure exerted by old managers on young ones, which, in turn, allows young managers to opt for more complex tasks than old managers. Thus, in equilibrium, there is a progressive increase in complexity and rents.
Post-trading
We analysed the situation in which protection buyers share risk with protection sellers in a derivative market, taking into account that, if protection sellers go bankrupt, they cannot give the insurance they promised (i.e. there is counterparty default risk.) We show that, when protection sellers take large positions in this derivative market, it creates a moral hazard problem, encouraging excessive risk-taking and increasing counterparty default risk. To mitigate this problem, privately optimal contracts involve variation margins. When margins are called, however, protection sellers must liquidate some of their assets. Such liquidations could lead to inefficient fire sales. If markets are complete, so that investors buying in a fire sale interim can also trade ex-ante with protection buyers, equilibrium is information-constrained efficient. Otherwise, privately optimal margin calls generate negative externalities via firesales. To curb the corresponding inefficiencies, ex-ante contracting among all relevant counterparties should be facilitated.
Trading
We studied the consequences for asset pricing and transaction volume of limited information collection and processing abilities. These imperfections generate allocative inefficiencies but not necessarily lower equilibrium prices. They also cause changes in preferences, leading to round trip transaction and excess trading volume.
We also studied high-frequency trading. High-speed market connections and information processing improve financial institutions' ability to identify and seize trading opportunities, which raises gains from trade. However, the same technological advances enable fast traders to process information and act upon it before slow traders, which generates adverse selection. In this context, investment waves arise, in which institutions invest in fast-trading technologies just to keep up with the others. When some traders become fast, it increases adverse selection costs for all, i.e. it generates negative externalities. Because of these externalities, equilibrium investment can exceed its welfare-maximizing counterpart. Pigovian taxes on investment in high-frequency trading technology can restore optimality.
We also studied whether human beings with limited cognition can reach the optimal risk-sharing and equilibrium price predicted by theory. To do so, we designed an experiment that closely emulates and tests the standard model of complete competitive markets, without imposing parametric restrictions on preferences. Consistent with theory, aggregated elicited supply and demand curves cross at the expected dividend when there is no aggregate risk, and at a lower price when there is aggregate risk. In contradiction with theory, individual participants frequently make first order stochastically dominated choices. We propose a random choice model, consistent with the above-mentioned findings, and with the finding that large mistakes are less frequent than smaller ones.
Finally, we studied whether there is something special about bond making it necessary to trade in fragmented markets and impossible to trade in transparent limit-order markets. We collected and analysed historical data showing that before WWII, there was an active market in corporate and municipal bonds on the NYSE. Activity dropped dramatically, in the late 1920s for municipals and in the mid 1940s for corporate, as trading migrated to the fragmented over-the-counter market. Average trading costs in municipal bonds on the NYSE were half as large in 1926-1927 as they are today in the fragmented over the counter market. Trading costs in corporate bonds for small investors in the 1940s were as low or lower than they are now. The difference in transactions costs likely reflects the differences in market structures, since underlying technological changes have likely reduced costs of matching buyers and sellers.
Managing
We studied how managers choose to adopt financial innovations, and how they choose more or less complex investment tasks. We allow for the possibility that financial managers be opportunistic and adopt innovations of choose complex tasks not because this is in the interest of the final investors, but because this can increase their own rents. These rents are agency rents, arising because of information asymmetries.
The combination of moral hazard and adverse selection amplify the boom and bust patterns associated with financial innovations and worsen risk--prevention. Thus, they generate excessively large and costly crises.
Complex tasks give rise to agency rents, and, for that reason, financial managers choose excessively complex tasks. In our overlapping generations model, there is competition between successive generations of managers. Old managers are an imperfect substitute for young ones, because the long horizons of young managers make them easier to incentivize, other things equal, than old managers with short horizons. This limits the competitive pressure exerted by old managers on young ones, which, in turn, allows young managers to opt for more complex tasks than old managers. Thus, in equilibrium, there is a progressive increase in complexity and rents.
Post-trading
We analysed the situation in which protection buyers share risk with protection sellers in a derivative market, taking into account that, if protection sellers go bankrupt, they cannot give the insurance they promised (i.e. there is counterparty default risk.) We show that, when protection sellers take large positions in this derivative market, it creates a moral hazard problem, encouraging excessive risk-taking and increasing counterparty default risk. To mitigate this problem, privately optimal contracts involve variation margins. When margins are called, however, protection sellers must liquidate some of their assets. Such liquidations could lead to inefficient fire sales. If markets are complete, so that investors buying in a fire sale interim can also trade ex-ante with protection buyers, equilibrium is information-constrained efficient. Otherwise, privately optimal margin calls generate negative externalities via firesales. To curb the corresponding inefficiencies, ex-ante contracting among all relevant counterparties should be facilitated.