Informed trading is an interesting research topic in the world of market micro-structure. My first foray into this area was when Prof. Maureen O'hara who was at the time chairman of Information Technology Group (ITG) and a Professor at Cornell University's Samuel Curtis Johnson Graduate School of Management. Maureen was also the first president of the American Finance Association (AFA). Pretty pretigious stuff.
Maureen was presenting her research at University of Queensland and was talking about her interactions with another famous industry quant, that was Marcos Le Prado about her paper on the VPIN Flow Toxicity metric, which basically is an indicator for informed trading. Apparently, Marcos out-of-the-blue contacted Maureen thanking her for her research paper and the VPIN model as it allowed him to get out of the market before the May 2010 Flash Crash. Initially, Maureen thought that Marcos was a bit of a nutter, but after delving a little deeper into his background she realized he was a bonafide quant and actually did use her model as a predictive indicator to avoid the Flash Crash. At that point, they published a paper and patented the VPIN metric. However, controversially, there came a series of papers that refuted their findings about whether the model was able to predict the flash crash.
Exposure to this work led me to initiate my own investigations on BV-VPIN at lower frequencies (i.e., daily) across multiple countries. This work can be found in the Publication and the paper is entitled BV–VPIN: Measuring the impact of order flow toxicity and liquidity on international equity markets. So I thought I'd write a short article on order flows, and market microstructure.
Brokers are simply the intermediaries that retail investors (i.e., people like you and me) and institutional investors (i.e., asset managers, pension funds) use to buy and sell stocks from the market. Market makers are usually member firms (i.e., Investment banks) of an exchange (i.e., Nasdaq, NYSE) that can create profits by buying/selling stocks on their own acccount or by taking profiting from the bid-ask spread. The bid-ask spread comes from the order book where there is a list of orders and the bid price and the asking price of each buy and sell order, respectively. Generally, the larger the spread between the bid and asking price, the higher the illiquidity of that asset. Market makers play an incredibly important role on financial markets as they ensure that stocks remain liquid and will sometimes purchase stocks and keep them on the trading book inventory rather than selling it shortly after to take advantage of the spread.
Each market maker contains a trading book that contains a list of stocks and the volume that has been purchased. This trading book is the inventory of what the market maker has to sell. Each day, this inventory of stocks needs to be valued and can be a point of controversy. Many traders who join a new team in an investment tend to try to re-value the trading book downwards and over the course of their employment will try to value this trading book upwards. Basically, traders can show that they are making the investment bank profits by buying and selling, or by showing that their inventory holds highly valuable stocks. Thus, if you joined the team and say the trading book was valued at $1M, you would try to argue in some shape or form that it is only worth say $800k and over the course of your employment try to grow that book to $1.2M as your bonus would be tied to the amount of profits you've made for the firm that is based on cash profits and the value of the trading book. Obviously there are means of controlling the valuation of the trading book by the firm; however, the point here is that the trading book valuation can be manipulated. Henceforth, Basel releasing new guidelines named Fundamental Review of the Trading Book. Much of the proprietary trading that occured during the Great Recession had to do with manipulation of the trading book where by investments were misvalued, and therefore many of these firms which had a large amount of these misvalued assets needed to be bailed out.
As market makers provide liquidity to the markets, they take risks by holding inventory on their trading book. Let's assume for now that the trading book inventory is held for the purposes of market making and not profiteering. If such is the case, market makers need to make sure that the stocks they are holding on inventory will not suddenly drop in value during the period at which they are holding these assets. Otherwise they will lose money. In this case, market makers need to minimize the risk that they are dealing with informed traders.
Informed traders are market participants that have knowledge that an asset might be heavily mispriced/misvalued and may drop in value. Thus, they might try to offload or short sell a large amount of stock to the market maker. The market maker needs to avoid such traders as they would be at risk of losing money if they bought the assets from these informed traders as it would be sitting in the market makers inventory.
As market makers are concerned about informed traders, they prefer to work with uninformed traders. Therefore, they will pay brokers to route trades from uninformed traders to them as this is where they are taking the least risk and able to profit from the bid-ask spread.
The pros of order flow payment are that because market makers are willing to pay for order flow from uninformed traders (i.e., retail investors, mum & dad investors), this decreases the brokerage costs to retail investors. However, the cons of order flow are that it reduces orders being routed to market makers who do not pay for order flow therefore increasing illiquidity at ther exchanges.
List of interesting topics