FIRST ANNUAL CONFERENCE ON THE REGULATION OF FINANCIAL MARKETS
Co-hosted with the Securities and Exchange Commission | May 16, 2014
The Rise and Fall of Securitization
Sergey Chernenko, Sam Hanson, Adi Sunderam
Abstract: The rise and fall of nontraditional securitizations—collateralized debt obligations and mortgage-backed securities backed by nonprime loans—played a central role in the financial crisis. Little is known, however, about the factors that drove the pre-crisis surge in investor demand for these products. Examining insurance companies’ and mutual funds’ holdings of fixed income securities, we find evidence suggesting that both agency problems and neglected risks played an important role in driving investor demand for nontraditional securitizations prior to crisis. We also use our holdings data to shed light on the factors that drove the dramatic collapse of securitization markets beginning in mid-2007. Contrary to conventional crisis narratives, we find little evidence of widespread fire sales. Instead, our evidence is more consistent with the idea that a self-amplifying buyers’ strike drove the dramatic collapse of securitization markets.
Alternatives for Issuer-Paid Credit Rating Agencies
Abstract: This paper investigates the welfare contribution and economic viability of alternatives to issuer-paid credit rating agencies (CRAs). To this end, it introduces a heterogeneous competition model for lending and ratings markets. Frictions among issuers or investors induce rating inflation from issuer-paid CRAs. Investor-paid CRAs suffer from three sources of free-riding and are generally not economically viable when competing with issuer-paid CRAs. Only for very limited parameter ranges can investor-paid CRAs thrive and counter rating inflation. Other proposed alternatives such as investor-produced ratings and CRA co-investments employ skin-in-the-game to induce proper accuracy. However, as traditional issuer-paid CRAs cater better to issuers, such alternatives generate little demand or are implemented ineffectively. Hence, this paper provides an explanation for the evolution, dominance and resiliency of issuer-paid CRAs.
Order Flow Segmentation and the Role of Dark Pool Trading in the Price Discovery of US Treasury Securities
Michael Fleming, Giang Nguyen
Abstract: This paper studies the workup protocol, a unique trading feature in the U.S. Treasury securities market that resembles a mechanism for discovering dark liquidity. We quantify its role in the price formation process in a model of the dynamics of price and segmented order flow induced by the protocol. We find that the dark liquidity pool generally contains less information than its transparent counterpart, but that its role is not trivial. We also show that workups are used more often around volatile times, but that their information role becomes relatively less important at those times compared to that of pre-workup trades. Higher usage of workups is also associated with higher market depth, lower bid-ask spreads, and higher trading intensity. Collectively, the evidence suggests that workups tend to be used more as a channel for liquidity providers to guard against adverse price movements, than as a channel to hide private information.
The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response
Eric Budish, Peter Cramton, John Shim
Abstract: We argue that the continuous limit order book is a flawed market design and propose that financial exchanges instead use frequent batch auctions: uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals, e.g., every 1 second. Our argument has four parts. First, we use millisecond-level direct-feed data from exchanges to show that the continuous limit order book market design does not really “work” in continuous time: market correlations completely break down at high-frequency time horizons. Second, we show that this correlation breakdown creates frequent technical arbitrage opportunities, available to whomever is fastest, which in turn creates an arms race to exploit such opportunities. Third, we develop a simple new theory model motivated by these empirical facts. The model shows that the arms race is not only socially wasteful – a prisoner’s dilemma built directly into the market design – but moreover that its cost is ultimately borne by investors via wider spreads and thinner markets. Last, we show that frequent batch auctions eliminate the arms race, both because they reduce the value of tiny speed advantages and because they transform competition on speed into competition on price. Consequently, frequent batch auctions lead to narrower spreads, deeper markets, and increased social welfare.
Corporate Use of Social Media
Michael J. Jung, James P. Naughton, Ahmed Tahoun, Clare Wang
Abstract: We examine corporate adoption of social media and provide the first large-sample evidence on the determinants and market consequences of the decision to disseminate quarterly earnings news through social media. We find that social media usage for earnings news is distinct from other forms of voluntary disclosure and document a number of interesting attributes of this disclosure mechanism. Social media usage for earnings news is inversely related to the number of social media followers, suggesting that firms with large social media followings are hesitant to use social media for financial information. However, we find that earnings news is more likely to be communicated when the news is positive, suggesting that some firms are opportunistic in their use of social media. Moreover, when we examine the market response to social media communications, we find that trading volume increases and that the primary driver is increases in large rather than small trades. This is inconsistent with the notion that social media primarily benefits small investors. Lastly, we find that the market reaction is stronger for firms that follow a consistent rather than ad hoc social media disclosure policy.
The Effect of the Say-on-Pay Vote in the U.S.
Peter Iliev and Svetla Vitanova
Abstract: We use a natural quasi-experiment to isolate the causal effect of holding advisory shareholder votes on executive compensation as mandated by the Dodd-Frank Act. Firms with a public float under $75 million did not have to hold a Say-on-Pay vote. Focusing on firms around the cutoff, we find a negative market reaction to the exemption from the Say-on-Pay rule. We find that the regulation increased both the level of CEO pay and the sensitivity of pay to performance. Firms did not avoid or postpone compliance, and did not change their compensation structure. We also document an increase in shareholder support for directors among firms that were required to hold a Say-on-Pay vote.
Governance Under the Gun: Spillover Effects of Hedge Fund Activism
Nickolay Gantchev, Oleg Gredil and Chotibhak Jotikasthira
Abstract: Hedge fund activism is a potent governance device associated with substantial improvements in the performance and governance of target firms. These positive changes often come at the expense of managers whose compensation and job security are threatened. However, due to the activists’ varying approaches and small ownership stakes, the threat of activism, unlike that of hostile takeovers in the past, is difficult to defend against with traditional tools such as poison pills. As a result, managers and directors are taking a more hands-on approach in evaluating and addressing potential vulnerabilities before an activist emerges. In this paper, we investigate the role of activism threat in motivating real policy changes at yet-to-be-targeted firms and examine whether such proactive responses are effective in fending off activists. We define threat as an abnormally high rate of recent activism in an industry and show that peers with fundamentals similar to those of previous targets are more affected by this threat. These threatened firms respond by reducing agency costs and improving operating performance in the same way as the actual targets. Such improvements lead to high abnormal returns and lower ex-post probability of becoming a target, suggesting that the proactive approach is indeed effective. Taken together, our results imply that shareholder activism, as a monitoring mechanism, reaches beyond the target firms.
Are Some Clients More Equal than Others? Evidence of Price Allocation by Delegated Portfolio Managers
Azi Ben-Rephael and Ryan D. Israelsen
Abstract: We use daily trades of management companies on behalf of their institutional clients to provide direct evidence of strategic price allocation. Focusing our attention on a subsample of “bunched trades” – a management company’s trades of the same stock, on the same day, in same the direction, for more than one client – we find that some clients receive systematically better prices than others. Average magnitudes can be as large as 0.50% of dollar trade volume. We find that clients who benefit outperform their counterparts by 0.15% per month and reward managers with a 15% - 30% increase in trading volume. This paper is the first to provide direct evidence of strategic performance allocation, and to reveal a new channel that could not previously be tested.