Anonymity, Adverse Selection and the Sorting of Interdealer Trades

This paper uses unique data from the London Stock Exchange to examine how the anonymity and liquidity of alternative trading venues affect dealers’ decisions about where to place interdealer trades. During the period we study, dealers could place non-anonymous trades with each other in the public market or use one of four anonymous and private brokered trading systems. Contrary to intuition and some theory, we find adverse selection is less prevalent in the anonymous brokered markets. We hypothesize and document that this pattern can be explained by the way dealers “price” the adverse selection risk inherent in trading with other dealers. We also discuss how our findings may bear on the increasing fragmentation of securities markets. In this paper we ask why London dealers use more than one trading venue to trade with one another. We argue that the presence of multiple trading venues allows dealers to price better the adverse selection risk present in interdealer trades. In particular, differences in the exclusivity, liquidity, anonymity, and post-trade transparency of each system permit a more efficient sorting of interdealer trades than if there were just one system. Our evidence comes from detailed data on where London dealers chose to place interdealer trades. Contrary to intuition, we show that uniformed interdealer trades (as measured by subsequent price impact) tend to migrate to third-party brokered systems where trade is anonymous. By contrast, informed interdealer trades tend to migrate to the direct (non-anonymous) public market. Additionally, we show that this distribution of trades is supported by differences in the price improvement dealers receive in the direct and brokered markets. Our findings have implications for three strands of the market microstructure literature. First, they contribute to our understanding of the importance of anonymity and transparency in securities trading. Most theoretical models of the effects of anonymity and transparency predict that anonymous trading systems will attract more informed trades (e.g., Röell (1990), Forster and George (1992), Fishman and Longstaff (1992), and Thiessen (2001)). Several empirical papers have recently explored the significance of anonymity and transparency in experimental settings (Bloomfield and O’Hara (1999), and Flood, Huisman, Koedijk, and Mahieu (1999)) and in real data (e.g., Foucault, Moinas, and Theissen (2003)). The evidence is so far mixed. Some studies find that anonymity and/or a lack of transparency can enhance liquidity at the expense of the informativeness of prices. Other studies conclude that anonymity and/or a lack of transparency can reduce liquidity but improve the informativeness of prices. While these experimental and empirical studies compare different market designs, they do not study what happens when traders can choose which trading system to use. Thus, the lessons that can be drawn from them for markets where dealers can access multiple venues, such as for the Nasdaq Stock Market, may be limited. By studying the choices of London dealers between anonymous and non-anonymous trading venues, we hope to add to our understanding of the role of anonymity in today’s