Unchecked intermediaries: Price manipulation in an emerging stock market

How costly is the poor governance of market intermediaries? Using unique trade level data from the stock market in Pakistan, we find that when brokers trade on their own behalf, they earn annual rates of return that are 50-90 percentage points higher than those earned by outside investors. Neither market timing nor liquidity provision by brokers can explain this profitability differential. Instead we find compelling evidence for a specific trade-based ‘‘pump and dump’’ price manipulation scheme: When prices are low, colluding brokers trade amongst themselves to artificially raise prices and attract positive-feedback traders. Once prices have risen, the former exit leaving the latter to suffer the ensuing price fall. Conservative estimates suggest these manipulation rents can account for almost a half of total broker earnings. These large rents may explain why market reforms are hard to see front matter r 2005 Elsevier B.V. All rights reserved. .jfineco.2004.06.014 xtremely grateful to the Securities and Exchange Commission Pakistan (SECP) for providing sed in this paper, and to Mr. Khalid Mirza and Mr. Haroon Sharif for clarifying questions. this paper do not necessarily represent the views of the SECP. We also thank Ulf Axelson, rjee, Nick Barberis, Gene Fama, Francisco Gomes, Simon Johnson, Steve Kaplan, Tobi Andrei Shleifer, Jeremy Stein, an anonymous referee, and seminar participants at Boston hicago GSB, Harvard, LSE, MIT, LUMS, Michigan, NBER, NEUDC Conference, and lpful comments and suggestions. All errors are our own. nding author. Fax: +773702 0458. dresses: [email protected] (A.I. Khwaja), [email protected] (A. Mian).