The Relevance of Broker Networks for Information Diffusion in the Stock Market

Marco  Di Maggio; Francesco  Franzoni; Amir  Kermani; Carlo  Sommavilla

Article | Journal of Financial Economics | November 2019

The Relevance of Broker Networks for Information Diffusion in the Stock Market

by Marco Di Maggio, Francesco Franzoni, Amir Kermani and Carlo Sommavilla

Abstract

This paper shows that the network of relationships between brokers and institutional investors shapes information diffusion in the stock market. We exploit trade-level data to show that central brokers gather information by executing informed trades, which is then leaked to their best clients. We show that after large informed trades, a significantly higher volume of other institutional investors execute similar trades through the same broker, allowing them to capture returns that are twice as large as their normal trading performance. Similarly, we show that the clients of the broker employed by activist investors to execute their trades tend to buy the same stocks just before the filing of the 13D. Informed traders find it profitable to concentrate their trades with a leaking broker because the loss due to the information leakage is more than compensated by the gains derived from trading on the information generated by the other clients of the broker.

Keywords: Business and Shareholder Relations; Information; Knowledge Dissemination; Financial Markets;

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Citation:

Di Maggio, Marco, Francesco Franzoni, Amir Kermani, and Carlo Sommavilla. "The Relevance of Broker Networks for Information Diffusion in the Stock Market." Journal of Financial Economics 134, no. 2 (November 2019): 419–446.

Using trade-level data, we study whether brokers play a role in spreading order flow information. We focus on large portfolio liquidations, which result in temporary drops in stock prices, and identify the brokers that intermediate these trades. We show that these brokers’ best clients tend to predate on the liquidating funds: at the beginning of the fire sale, they sell their holdings in the liquidated stocks in order to then cover their positions once asset prices start recovering. The predatory trades generate at least 50 basis points over ten days and cause the liquidation costs for the distressed fund to almost double. These results suggest a broker’s role in fostering predatory behavior and raise a red flag for regulators. Moreover, our findings highlight the trade-off between slow execution and potential information leakage in the decision of optimal trading speed.

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The Relevance of Broker Networks for Information Diffusion in the Stock Market

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