Thursday 12 November 2009

Insider trading and currency markets

I'd never before heard this hypothesis (I'm not a finance guy), but it makes a lot of sense. Banks have tons of information on their clients' trades; they can aggregate this up to get a sense of where things are heading.
Abstract:
This paper provides evidence that hedge funds are a critical source of private fundamental information in currency markets. We analyze the most disaggregated database of currency transactions to date, with ten different categories of market participants including six categories of end users. Our analysis of the information content of individual trades indicates that only one category of end user has information, specifically hedge funds. Orders placed by institutional investors, broker-dealers, central banks and government agencies, large corporations, and middle-market corporations provide little information about upcoming returns. Orders of banks in every size category carry information, consistent with now-standard theory that banks gather information from observing customer trades. Theory does not indicate whether banks should be better informed than their customers. Our results suggest that banks are better informed than their individual customers, possibly because they aggregate information from many customers.
Osler and Vandrovych, via Wayne Marr's Twitter feed.

From the paper's conclusion:
We find that stop-loss orders from all four bank groups have a statistically significant price impact that is statistically indistinguishable from the impact of leveraged investors’ stoploss orders at horizons below 12 hours. Thus our results are consistent with the hypothesis that members of the dealing community learn exchange-rate relevant information from observing customers order flow (Evans and Lyons 2002). At longer horizons, however, dealers trades appear to carry information while the leveraged-investor trades do not. This suggests that dealers, by observing the trades of many customers, are ultimately better informed than their customers taken individually.
Update: Don Boudreaux has useful thoughts on insider trading.

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