Does the Market Conspire Against the Weak? An Empirical Study of Front Running Behavior During the LTCM Crisis

Abstract:     
Most microstructure models assume that market makers are uninformed and that they trade competitively. However, empirical evidence about market makers' trading behavior is still relatively scant. This paper uses a unique audit trail transactions dataset to investigate the trading behavior of market makers in the Treasury bond futures market when Long-Term Capital Management (LTCM) faced binding margin constraints during its 1998 crisis. There is strong evidence that market makers on aggregate engaged in front running against LTCM; i.e., market makers traded on their own accounts in the same direction just one or two minutes ahead of LTCM. Furthermore, a significant percentage of market makers made abnormal profits on most of the trading days during the crisis. Their aggregate initial abnormal profits, however, were more than offset by abnormal losses after the bailout orchestrated by the Fed. Moreover, I show that before the bailout, a market maker's cumulative abnormal profit was positively correlated to the intensity of his front running, but this relation turned negative after the bailout. The overall evidence suggests that, although market makers attempted to take advantage of LTCM's financial distress by front running, the bailout was a successful intervention that relaxed LTCM's binding constraints and therefore negated the profitability of front running.

Keywords: Front running, strategic trading, market microstructure, trading behavior, margin constraints, financial crisis

JEL Classifications: E44, G10, G14

Working Paper Series