Getting out early: An analysis of market-making activity

Stock market analysts move markets, and not just because investors believe in the validity of their research and legitimacy of their opinions. In an important new study, Assistant Professors Jennifer L. Juergens and Laura Lindsey examined affiliated market-making activity around analyst recommendation changes and found a dramatic effect on trading activity for the issuing brokerage firms around both upgrades and downgrades.

Stock market analysts move markets, and not just because investors believe in the validity of their research and legitimacy of their opinions. In an important new study, Assistant Professors Jennifer L. Juergens and Laura Lindsey explore how changes in analyst recommendations affect Nasdaq securities' trading volume at the market maker of the analyst's firm.

(Market makers quote both a buy and a sell price in a particular stock, profiting on the spread between the two prices. By being on the other side of trades when there are short-term buy- and sell-side imbalances in customer orders, they provide necessary liquidity to a security's market.) Juergens and Lindsey found on days when an analyst released recommendations, total trading volume dramatically increased at the analyst's firm relative to other market makers, and that this difference is not explained by better pricing.

Lindsey notes, "Generating research is expensive for brokerage houses. The increase in total market making volume in response to upgrades and downgrades constitutes new evidence of compensation for research production." On days when upgrades are released, buying volume increases appreciably at the recommending market maker's firm. For downgrades, however, there is no disproportional sell volume on the day of the recommendation release.

Instead, there is evidence of increased selling at the downgrading analyst's firm in the two days prior to the official release of a downgrade. Some investors are apparently getting out early. Juergens said, "Particularly in light of recent regulatory changes, these findings raise questions about the selective release of negative news."

Volume

Increased trading benefits all market makers, but especially the issuing analyst's firm. Average affiliated share volume more than doubles, as does dollar volume. Market share increases by more than a percentage point. For unaffiliated market makers, the increased activity is smaller in magnitude, and measurably smaller for total volume and average trade size. Finding statistically significant increases in volume for all market makers, even unaffiliated market makers, is not surprising since investors and market makers from unaffiliated firms would have access to the recommendation change information after the official release.

Also, clientele of affiliated firms may shift order flow away from the recommending firm to others with whom they have soft-dollar agreements. (Some investors make arrangements with brokerage houses where in exchange for research information they agree to spend a certain amount on trading commissions; these are called soft-dollar agreements.) What is particularly surprising is that there is some evidence in the general volume measures of increased trading activity at affiliated firms two days before downgrades.

Two explanations account for the increase in trading at the affiliated firm's market maker prior to the official information release. The first possibility would be that analysts react to abnormal sell volume at their own firms' market makers, which doesn't appear to be the case. The second is that information is leaked in-house or to important institutional clients of the firm. This evidence indicates an internal or limited pre-release of analyst opinion changes prior to the public release date, suggesting that some clients have an informational advantage.

Block trading

If the market maker is alerting important clients to the impending downgrade or the firm itself is trading ahead of the public release, one might expect to see evidence of increased institutional activity through block trading. Of course, this measure is imperfect since investors may break up their trades in order to "stealth trade" on private information rather than risk signaling others of their activity. (There are other reasons to break up trades, such as execution costs, etc.; therefore, not all institutional trading that is broken into smaller trade sizes reflects information-motivated trades)

Interestingly, for upgrades, there does not appear to be increased institutional buying, as indicated by block trading, on days when affiliated analysts issue an upgrade. Since there is an increase in overall trading, the proportional buying effect for affiliated upgrades may be confined to small investors who are clients of the brokerage firm. For downgrades, the pattern is quite different. There is no increase in proportional sell volume for market makers with an affiliated downgrade on the recommendation release day.

There is, however, evidence of elevated institutional selling, as measured by proportional block sell volume, through the market maker whose analyst is about to issue a downgrade in the days prior to the official release date. These results are consistent with alerting clients to the impending downgrade, though one cannot rule out firms trading for their own account.

Proprietary trading desks

In the two days prior to downgrades, disproportional increases in sell volume are confined to firms that trade on behalf of the brokerage firm's own house account, though most large brokerage firms have proprietary trading activity. On the day prior to the recommendation, the disproportional sell volume extends to market makers who act strictly in an agency capacity on behalf of their clients.

Thus, there is some evidence of early sell volume at firms that are only acting on behalf of clients. The data shows that the phenomenon holds for a large cross-section of Nasdaq securities and market participants. Interestingly, the ten brokerage firms fined $1.4 billion in the 2002 Global Research Analyst Settlement Agreement (for allegedly biasing research reports in order to garner investment-banking business) do not appear to be the firms disseminating information prior to public releases.

Conclusion

This paper examines affiliated market-making activity around analyst recommendation changes and finds a dramatic effect on trading activity for the issuing brokerage firms around both upgrades and downgrades. As Lindsey states, "This effect has real and significant monetary implications for these firms, as both trading commissions and execution fees from spreads are generated from increased trading volume."

Disproportionate sell volume prior to the downgrade date appears to be institutional volume and at least some of the volume comes from clients of the firm. This study contributes to the literature that suggests the existence of informed trading prior to the public release of analyst recommendations. Juergens summarizes, "Even in this post-regulatory environment, some investors appear to receive more valuable information than others."

Bottom Line:

• Changes in analyst recommendations generate trading activity.
• Market makers benefit from the trading commissions and spread fees as a result of the increased volume.
• In the two days prior to the release of a downgrade, affiliated market makers with proprietary trading desks see a disproportionate amount of institutional sell volume.
• On the day prior to a downgrade, market makers at the downgrading firm who act solely on behalf of clients also witness increased sell volume, suggesting that some outside investors are alerted to the impending downgrade and trade accordingly.