Courtesy of Knowledge@Wharton

A belief that market makers at institutional brokerages are "naïve" providers of liquidity -- uninformed players operating from behind a firm Chinese Wall -- may itself be an uninformed presumption.

Market makers are specialized intermediaries, registered with the New York Stock Exchange and the NASDAQ, who provide liquidity through the buying and selling of large volumes of securities. The Wharton researchers, in a detailed parsing of four years of insider trading at 15 of Wall Street's largest brokerages, find that market makers executing insider trades at these firms appear to act on information gleaned from those trades.

The evidence can be seen in the more aggressive prices they set for the company's stock following an insider trade. Put another way, compared to their peers, market makers affiliated with the brokers used by insiders post more aggressive ask quotes during periods when insiders trade. The study was undertaken using information from trades made between March 1999 and November 2003.

"Academics and, to some degree, those who trade in the market, might assume that market makers are there simply to take the other sides of trades and provide liquidity, whereas it looks as though they may have, and may act on, information," says Géczy. "What we found is that there is a leakage somewhere along the lines in the information transmission channel between the investor -- in this case, company insiders -- and ultimate trades, and the way information is transmitted into the market in the form of buy or sell orders."

The term for this behavior is "piggybacking." Géczy and Yan found that the less information or certainty around a given company, the greater the impact of insider transactions on market makers' behavior. The ensuing piggybacking is affected by the number of analysts covering the company (or the amount of public information available); the spread of analysts' company forecasts; the bid-ask spread of the stock, and post-event stock returns.

The forecast spread reflects analysts' degree of certainty about a company's future performance. The wider the bid-ask spread, the greater the uncertainty, and therefore the liquidity, of that stock. Piggybacking diminishes, the authors found, when the firm of the broker-dealer making markets has had a prior investment banking business relationship with the company doing the insider trading.

"In a classical theory framework, market makers who provide liquidity to a market with informed and uninformed investors do not possess superior information. However, the model implications are not entirely consistent with some recent empirical evidence," states Yan. "One important implication of our results is to call for a more careful study of the market structure. What if the market maker is informed? And how should we understand the market structure differently? I think, ultimately, the fairness and transparency of the market are crucial to making a competitive capital market."

Yan's remarks point to the significance of the timing of the research. In 2000, well into the study's four-year period, the Securities and Exchange Commission adopted Regulation FD (short for "full disclosure"), which banned the selective disclosure of information by corporations to large shareholders and securities analysts. Géczy and Yan report that their work provides evidence that Regulation FD is working, at least with respect to the information they examined, and that information leakage slowed after the SEC's action.