Traders’ Broker Choice, Market Liquidity and Market Structure

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Staff Reports

Traders Broker Choice, Market Liquidity and Market Structure

August 1997 Number 28

JEL classification: G12, G13, G18

Authors: Sugato Chakravarty and Asani Sarkar

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).

Available only in PDF PDF

43 pages / 192 kb

For a published version of this report, see Sugato Chakravarty and Asani Sarkar, "A Model of Brokers' Trading, with Applications to Order Flow Internalization," Review of Financial Economics 11, no. 1 (2002): 19-36.

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