Clients' Connections: Measuring the Role of Private Information in Decentralized Markets

Abstract

We propose a new measure of private information in decentralized marketsconnections-which exploits the time variation in the number of dealers with whom a client trades in a time period. Using trade-level data for the U.K. government bond market, we show that clients perform better when having more connections as their trades predict future price movements. Time variation in market-wide connections also helps explain yield dynamics. Given our novel measure, we present two applications suggesting that (i) dealers pass on information, acquired from their informed clients, to their affiliates, and (ii) informed clients better predict the orderflow intermediated by their dealers.A MAIN ROLE OF FINANCIAL markets is to aggregate private information held by economic agents. Trading activity and subsequent adjustments in asset prices release this information to the wider public, thereby making markets more efficient and increasing the welfare of society. The main challenge facing any scientific study of this mechanism is that neither private information nor the identities of its owners are readily observable.Our paper proposes a proxy for private information. We combine a detailed data set of the U.K. government bond market, which includes trading parties' identities and transactions, with insights from the microstructure literature.

Informed Trading and the Dynamics of Client-Dealer Connections in Corporate Bond Markets

“…The inclusion of client-day fixed effects allows us to control for the effects of such time-varying, client-specific shocks. This also strengthens our empirical design compared to previous studies such as Kondor and Pinter (2022) which did not exploit asset-level heterogeneity. Another possible concern is that our results are driven by correlated trading needs of uninformed investors, resulting in a spurious correlation between bond returns and client connections.…”

“…However, the effects at the baseline client-day-bond level are about five times larger than those at the client-day level. This suggests that asset-level heterogeneity plays an important role for informational trading in corporate bond markets, particularly when compared to government bond markets (Kondor and Pinter, 2022).…”

“…Therefore, we are able to extend our analysis of corporate bond markets, and contrast it to studies on government bond markets (e.g. Kondor and Pinter, 2022). Specifically, we can estimate how the sensitivity of performance to client connections differs between corporate and government bond markets, while controlling for unobserved heterogeneity at the client-day level, e.g.…”

“…The performance measures are in %-points. We include the natural logarithm of both the pound trade volume of the particular client in the given market ("Volume") and her number of trades ("# Trades") as additional controls, as in Kondor and Pinter (2022). To reduce noise, we winsorise the sample at the 1%-level.…”

“…Closest to our empirical analysis are two recent papers. First, Kondor and Pinter (2022) analyses the relation between client-dealer connections and performance in government bond markets. Compared to their approach, we exploit the asset-level heterogeneity as well as other specific features of corporate bond markets to develop our empirical tests; and we are also able to compare the effects of connections across markets by identifying a common set of clients operating simultaneously in corporate and government bond markets.…”