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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 study by Amber Anand, associate professor of finance in the Whitman School of Management, and Avanidhar Subrahmanyam, the Goldyne and Irwin Hearsh Chair in Money and Banking at the UCLA Anderson Graduate School of Management, 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 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 don’t see anything the rest of the world doesn’t see in order to determine if intermediaries still have an informational advantage.”
Anand continues, “Our results clearly show that intermediaries tend to have more information than other traders in the market. The question is, what is the source of this information?”
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 Amber Anand is an associate professor of finance in the Whitman School of Management. He earned his PhD at Baruch College of the City University of New York. Anand’s research interests include the microstructure of stock and options markets, market design, trading rules, price discovery, and trader behavior. His research has been published in the Journal of Financial Markets and the Journal of Financial and Quantitative Analysis, among other leading industry journals. Anand’s current research focuses on investigating the importance of designated market makers in electronic markets, the role of geography in market making, and the impact of transaction costs on fund returns.
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Anand’s research, published in the Journal of Financial and Quantitative Analysis, shows that skills in forecasting short-term order flow, experience at trading, and well-honed intuition play a role in intermediary advantage more than access to the trading floor.
“Ultimately, we found that making a market electronic will not eliminate the informational 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 front running their clients, however. Instead, it is their skills at being intermediaries that give them a greater comparative advantage 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.
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