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

54 Pages Posted: 4 Dec 2001

Date Written: May 2002

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 Classification: E44, G10, G14

Suggested Citation

Cai, Fang, Does the Market Conspire Against the Weak? An Empirical Study of Front Running Behavior During the Ltcm Crisis (May 2002). Available at SSRN: https://ssrn.com/abstract=292765 or http://dx.doi.org/10.2139/ssrn.292765

Fang Cai (Contact Author)

Federal Reserve Board ( email )

Office of Financial Stability Policy and Research
1801 K St NW
Washington, DC 20551
United States
202-452-3540 (Phone)
202-263-4850 (Fax)

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