Brokers and Order Flow Leakage: Evidence from Fire Sales

Abstract

Using trade‐level data, we study whether brokers play a role in spreading order flow information in the stock market. We focus on large portfolio liquidations that result in temporary price drops, and identify the brokers who intermediate these trades. These brokers’ clients are more likely to predate on the liquidating funds than to provide liquidity. Predation leads to profits of about 25 basis points over 10 days and increases the liquidation costs of the distressed fund by 40%. This evidence suggests a role of information leakage in exacerbating fire sales.

High‐Frequency Trading around Large Institutional Orders

“…Barbon et al. () provide evidence suggesting that brokers who execute large positions on behalf of clients at fire sale prices may share this information with other clients, who, in turn, prey on these large orders. The incentive for the broker, they argue, is to establish a reputation of having valuable information.…”

The Value of Intermediation in the Stock Market

“…Moreover, they document that the best institutional clients are compensated with the allocation of superior information around changes of analyst recommendations. Other work shows that the best institutional clients of brokers also receive privileged information about informed order flow (Di Maggio, Franzoni, Kermani, and Sommavilla (2019)) and ongoing fire sales (Barbon, Di Maggio, Franzoni, and Landier (2019)). Evidence that brokers pass valuable information to selected clients is also present in Irvine, Lipson, and Puckett (2006) regarding future analyst recommendations, in McNally, Shkilko, and Smith (2015) and Li, Mukherjee, and Sen (2017) regarding insiders' order flow, and in Chung and Kang (2016) for hedge fund trading strategies.…”

“…Information Recent evidence has highlighted the role played by financial intermediaries in creating value through information production (Babus and Kondor, 2018;Barbon et al 2019). Brokers may have access to additional information about market conditions, trends and specific stocks due to the structure of the market and the counterparties that the brokers deal with on a daily basis.…”

“…Recent studies by Barbon, Di Maggio, Franzoni, and Landier (2019) and Di Maggio, Franzoni, Kermani, and Sommavilla ( 2019) have shown that brokers are an important hub for order flow information, which can be strategically released to some investors in order to attract their business.…”

The Life of the Counterparty: Shock Propagation in Hedge Fund-Prime Broker Credit Networks

“…12 Kumar, Mullally, Ray, and Tang (2017) provide evidence that hedge funds obtain early information from their prime brokers about corporate clients that obtain loans from the prime broker's investment bank. Barbon, Maggio, Franzoni, and Landier (2019) find that brokers leak information on fire sales to their best clients. Sinclair (2016) examines the capital introduction service provided by prime brokers to help hedge funds connect with investors and finds that prime brokers do indeed affect capital allocation in the hedge fund industry.…”