Financial Networks and Trading in Bond Markets
G. Geoffrey Booth
EliBroadGraduateSchool of Management, MichiganStateUniversity
Umit G. Gurun
School of Management, University of Texas at Dallas
Harold H. Zhang
School of Management, University of Texas at Dallas
This paper examines the role of financial networks in influencing asset prices and trading performance. Consistent with theoretical studies on the role of communication networks in information dissemination, we posit that financial institutions with more extensive financial networks (global financial institutions)can more efficiently acquire and process information pertaining to asset trading in global financial markets than financial institutions with more limited financial networks(local financial institutions). The information advantage affords the global financial institutions more favorable transaction prices and better trading performance relative to their local counterparts. Using transaction-level Turkish government bond tradingdata, we find that financial institutions with global financial networks exhibit a stronger tendency to trade in the more liquidbonds. Further, they consistently trade at more favorable prices and enjoy better trading performance than local financial institutions. Together, these results suggest that global financial institutions have information advantagesand benefit from bond trading in an open emerging market.
Key Words: Financial Networks, Information, BondMarkets
1.Introduction
Although it is well established that information moves security prices, how information flows through financial markets and is incorporated in the prices of financial assets is not as well understood. Traditional asset pricing approaches assume that individual agents behave anonymously with new information becoming known by all the agents in the market simultaneously, thereby making the information common knowledge. Information, however, can also gradually spread throughout the market by word-of-mouth and observational learning. Because of differences in institutional structures and traders’ information processing abilities, it is unlikely that information diffusion will be amorphous. Instead, information is likely to spread more rapidly within trading firms than between trading firms, not only because of the presence of an intra-firm network but also because of financial incentives provided to traders that are related to firm profitability.As a result, traditional approaches disregard the possibility that agent behavior (individually and collectively) may be influenced by a communication network.
Models of trading dynamics recognize the presence of asymmetric information.The distinction between informed and uninformed traders leads to a number of useful insights. For instance, informed traders tend to respond more quickly to news, tend to trade in more liquid markets, and tend to show better performance than uninformed traders. Yet it is not entirely clear who the informed traders are or how they become informed. In this regard several empirical studies show that individuals who reside and work in the same location tend to make similar financial decisions, which suggests the presence of internal group communication.[1] The idea is that traders who are spatially and electronically close are exposed to similar information that is diffused via networks within the same group once the information is received by one or more of the traders.
We address this gap in the literature by comparing the information networks of financial institutions that trade bonds in an emerging market.We select this type of market because, as Biais and Green (2005) point out, bond markets often provide little pre-trading transparency, which creates opportunities for informed traders to take advantage of their superior information.We classify the sample institutions as those that have offices in the local economy only and those that have offices both in the local economy and in major bond trading markets such as New York City and London. We define a financial network to be a set of offices that are linked together by an electronic communication system.
Consistent with the implications of theoretical studies on the role of networks in information dissemination, we posit that a financial institution with a global (more extensive) financial network can more efficiently acquire and process information related to global financial market movements than an institution with only a local (less extensive) network. This information advantage is expected to allow global financial institutions to trade more nimbly and perform betterrelative to local financial institutions.
We test our hypotheses by empirically investigating daytrading in the government bonds of Turkey, an open emerging market in which financial institutions with different scopes of financial networks are permitted to participate with limited government interference. We find that financial institutions with global financial networks trade at more favorable prices and demonstrate better performance in the Turkish government bond market relative to financial institutions with only local networks. Our empirical findings thus support the conjecture that financial institutions with a more extensive financial network such as those with a global network exhibit an information advantage and benefit from utilizing their superior information relative to financial institutions with a less extensive financial network such as those with only a local network.
2.The Bonds and Bills Market
2.1 The Market
Turkey’s public bond market, the Bonds and Bills Market, is an important investment and trading venue for financial institutions. Using total market capitalization standardized by GDP as a measure ofimportance, according to World Bank Database on Financial Development and Structure, Turkey ranked 9th out of 30 major world bond markets, with its bond market being 2.3 times as large as its equity market (see Beck et al. (2000) for details of this database).
Almost every month, the Turkish Treasury auctions bonds with maturities ranging from one month to 10 years. After the primary market allocation, these bonds are traded on an automated secondary market, the Bonds and Bills Market. This market also facilitates repurchase agreements, but these transactions are executed separately and excluded from our analysis. The institutions that are authorized to trade on the Bonds and Bills Market are Istanbul Stock Exchange (ISE)member banks and member brokerage houses. These financial institutions typically trade on their own accounts. Sometimes they fill retail buy orders from their inventory, but if their inventory is insufficient they may have to go to market to meet demand.
Each institution employs multiple traders who form an information network. They are in constant contact with each other throughout the trading day, permitting them to be better aware of the local buy and sell order flow. For instance, it is not uncommon for traders to inform the participants in their network that they have learned that a particular financial institution is a net buyer today or that another financial institution is trying to liquidate a sizeable position. Some institutions have home offices in multiple markets while others have branches; such organizational structures create multi-market trader networks that facilitate the transmission of information relevant to the local market.
Bond market participants area diverse mix of small and large Turkish financial institutions and large international financial institutions.These institutions have different arrangements to disseminating information. International banks, for instance, have their bond trading floors connected by a “hoot”. Nowadays a “hoot” refers to an electronic communication system, but originally it was a device devoted to a single trading floor. “Hoot” transmissions tend to flow from New York and London to other markets. In contrast, bond traders of Turkish banks (especially large Turkish banks) gather information by making phone calls to fellow bond traders in overseas financial centers.Of course, information is also available to all traders whose firms have access to public information networks such as Reuters, Bloomberg, and similar providers. Different financial institutions, however, may still have different information processing capabilities, which may lead to differences in interpretation of publicly released information and in turn trading performance.
2.2 The Trading System
The Bonds and Bills Market is a limit order book market that uses an electronic system to match, administer, and report transactions. The market operates in two sessions: from 9:30 a.m. to 12:00 noon, and from 1:00 p.m. to 5:00 p.m. Bonds with same-day and next-day settlement trade until 2:00 p.m., which is the settlement time for the day; between 2:00 p.m. and closing, only bonds with next-day settlement trade. Thus, the number of transactions declines noticeably after 2:00 p.m.
Orders are processed and executed according to price andtimepriority in an automated trading system. The ISE uses an order-driven electroniccontinuous market with no intermediary such as a market maker and no floor brokers. The majority of the orders are routed electronically via member firms to the central limit order book through an order processing system that does not require any re-entry by the member firms. In very rare cases, member firms call representatives at the exchange to have their orders entered for them. Member firms can execute market orders and limit orders, as well as orders that require further conditions for execution (e.g., Fill-or-kill and Stop-loss). Member firms are not allowed to enter orders when the market is not open; however, they are allowed to withdraw their existing orders. It is not unusual to see traders filling out their order screen prior to opening time and submitting multiple orders at the open.
Price information on the 20 best bids and offers is continuously available to member firms. The system does not display quantity demanded or offered at each of these prices, but past transactions can be viewed by all members. The tick size is 1 Turkish lira (TL) for a 100,000 TL face value bond, with minimum (maximum) order size set to 100,000 TL (10 million TL); there exists no formal upstairs marketfor block trades. An incoming market order is executed automaticallyagainst the best limit orders in the book. Execution within the inside quotes is allowed.
Once a transaction takes place, a confirmation notice is sent to the parties involved in the transaction. The other market participants do not learn the identities of the parties, but they do observe that a transaction took place at a specific price and quantity.All information pertaining to price, yield, and volume of best orders as well as details of the last transaction and a summary of all transactions are disseminated to data vendors, including Bloomberg, Reuters, and some local firms, immediately after each transaction. In addition, all trades are reported to the clearing organization, the ISE Settlement and Custody Bank Inc. (Takas Bank), at the end of the day to facilitate bookkeeping. We do not have information on what percentage of the transactions take place in ISE; however, anecdotal evidence suggests that ISE consolidates more than 97% of the turnover value of the Bonds and Bills Market’s transactions. The remaining portion is captured by OTC markets.
The Turkish government typically plays a minimal role in the Bonds and Mills Market. Nevertheless, after the 2001 banking crisis, the Undersecretariat of the Treasury initiated a primary dealer system that requires some market’s membersthat participate in the primary market auction to provide liquidity by quoting a bid and an ask (not necessarily the best bid or ask) in the secondary market. The quotes are identified as being given by a primary dealer. The rationale for this innovation is that these members would accommodate liquidity needs that may arise during times of crisis, although anecdotal evidence indicates that such action by the primary dealers has yet to occur. The number of primary dealer members (typically between eight and 14) and its composition (foreign or domestic) is determined by the Undersecretariat. In 2006, the primary dealer system consisted of 12 primary dealers. The most recently issued bond is designated as the active (or benchmark) bond.
3. Data and Summary Statistics
Our sample consists of 1,716,917 tick-by-tick time-stamped transactions beginning May 1, 2001 and ending June 15, 2005 (1,039 trading days). For each transaction, we have detailed information on the time of order placed and filled, transaction price, and trade size for 177 Turkish lira-denominated Treasury bills and notes. More important, our data set also containsthe identities of the traders on both sides of a transaction from their unique identification code. The starting date of the sample is two months after the Turkish financial crisis attributed to liquidity shortages in the banking system that ended in February 2001. Data availability dictates the sample’s ending date.
One hundred seventy distinct financial institutions participated in the Bonds and Bills Market. We classify these into local versus global financial institutions. A financial institution is classified as “global” if it has branches or offices in major financial markets outside Turkey; otherwise, it is classified as “local”. Based on information collected from the Istanbul Stock Exchange and data from the Turkish Bank Association ( on overseas branches and offices, we classify 146 as local financial institutions and 24 as global financial institutions.We use the ISE asset size categories to divide local financial institutions into 116 small and 30 large financial institutions.[2]
The roster of global financial institutions includes large foreign banks such as Deutsche Bank, Citibank, and JP Morgan Chase as well as large domestic financial institutions such as Yapı Kredi Bankası A.Ş., Vakıflar Bankası A.Ş., and Akbank A.Ş. The foreign global financial institutions have home offices in New York and throughout Europe, with the latter including offices in London, Amsterdam, Paris, and Frankfurt to name but a few. Six of the global financial institutions are Turkish and together account for more than 22% of the global financial institutions’ participation in the Turkish market. These financial institutions have branch and liaison offices not only in New York and Europe but also in Bahrain, Tokyo, and Moscow.[3]
Using the trader identification code, our global versus local classification, and ISE asset size categories, we classify each transaction as being made by a local small, local large, or global financial institution. Table 1 reports selectivesummary statistics for our data. Panel A shows the average daily trading volume in U.S. dollars (USD) of the local small, local large, and globalfinancial institutions sorted by seller- and buyer-initiated trades and their counterparties.[4] Of the USD 640 million of total daily volume, trading between local large and global financial institutionsis the highest, with average daily trading volume reaching USD 133.8 million for seller-initiated trades and USD 139 million for buyer-initiated trades. Trading among globalfinancial institutions is the second highest,with seller- and buyer-initiated daily trading volume of USD 76.5 million and USD 95.6 million, respectively.
In Panel B, we report the average size and number of tick-by-tick transactions for local small, local large, and global financial institutions without reference to the initiator. The average volume per transaction is highest, at USD 0.9 million, between local large and global financial institutions. The transaction volume for trades among global financial institutions is the second highest at USD 0.65 million, while trades betweenlocal small and global financial institutions ranks third. In terms of the number of transactions, trades between local large and global financial institutions account for 36.9% of all trades, trades among local large financial institutions account for 21.7%, and trades among global financial institutions account for 16.1%.
4.Empirical Analysis and Results
Our analysis consists of three distinct but related analyses. We first examine whether global financial institutions are more likely to trade more liquid bonds, a practice that allows them to more easily hide informed strategic trades. We then investigate whether global financial institutions consistently transact at more favorable prices. Finally, we explore the day-trading profitability by different financial institutions. The evidence supports the notion that financial institutions with global information networks are more informed than those institutions with only local networks.
4.1 Strategic Trading
Chowdry and Nanda (1991) show that informed investors tend to trade in more liquid markets, presumably because of their needto hide strategic transactions that convey information. Combining this observation with Pasquariello and Vega’s (2007) suggestion that the most liquid bonds are the ones that are most recently issued, we hypothesize that if global financial institutions have an informational advantage over local financial institutions, they tend to trade active bonds, i.e., the most recently issued bonds, relative to the other bonds, which we refer to as passive bonds.
In Table 2 we report different financial institutions’ average daily transactions—measured by volume of trade (in U.S. dollars) and number of trades—in active bonds and passive bonds and the daily ratio of trading in active bonds to passive bonds. Consistent with Pasquariello and Vega (2007), active bonds have the highest transaction volume/number compared to the rest of the bonds. As a robustness check, we calculate the transaction volume at day t-1 and designate the bond with highest score as the active bond for the next trading day. Our conclusions are not affected by this alternative definition of “active” bond.