Traders' Broker Choice, Market Liquidity and Market Structure

43 Pages Posted: 11 Nov 2006

Date Written: August 1997

Abstract

Hedgers and a risk-neutral informed trader choose between a broker who takes a position in the asset (a capital broker) and a broker who does not (a discount broker). The capital broker exploits order flow information to mimic informed trades and offset hedgers' trades, reducing informed profits and hedgers' utility. But the capital broker has a larger capacity to execute hedgers' orders, increasing market depth. In equilibrium, hedgers choose the broker with the lowest price per unit of utility while the informed trader chooses the broker with the lowest price per unit of the informed order flow. However, the chosen broker may not be the one with whom market depth and net order flow are higher.

We relate traders' broker choice to market structure and show that the capital broker benefits customers relatively more in developed securities - i.e., markets where there are many hedgers with low levels of risk aversion and endowment risk, where the information precision is high and the asset volatility is low. The discount broker benefits customers relatively more in volatile markets where there are few hedgers with high levels of risk aversion and endowment volatility, and where information is imprecise. We derive testable predictions from our model and successfully explain up to 70 percent of the daily variation in the number of discount brokers and capital brokers (or, dual traders in futures markets).

JEL Classification: G12, G13, G18

Suggested Citation

Chakravarty, Sugato and Sarkar, Asani, Traders' Broker Choice, Market Liquidity and Market Structure (August 1997). Available at SSRN: https://ssrn.com/abstract=943510 or http://dx.doi.org/10.2139/ssrn.943510

Asani Sarkar (Contact Author)

Federal Reserve Bank of New York ( email )

Research Department
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212-720-1582 (Fax)

HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

No contact information is available for Sugato Chakravarty

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