Strategic Learning and Trading in Broker-Mediated Markets

TL;DR

This paper analyzes strategic interactions in broker-mediated markets, showing how information leakage and strategic inference affect trader and broker performance, revealing a strategic advantage for brokers over traders relying solely on prices.

Contribution

It introduces a model of strategic learning and trading in broker-mediated markets, highlighting how information leakage creates economic value and affects market dynamics.

Findings

Brokers can profitably speculate by exploiting information leakage.

Information leakage significantly impacts trader performance and market efficiency.

Brokers holding a strategic advantage over traders relying only on prices.

Abstract

We study strategic interactions in a broker-mediated market in which agents learn and exploit each other's private information. A broker provides liquidity to an informed trader and to noise traders while managing inventory in a lit market. The informed trader infers the broker's trading activity in the lit market, while the broker estimates the trader's private signal. Information leakage in the client's trading flow generates economic value for the broker that is comparable in magnitude to transaction costs: the broker can speculate profitably and manage risk more effectively, which in turn adversely affects the informed trader's performance. Brokers therefore hold a strategic advantage over traders who rely solely on prices to filter information. When the broker only relies on prices rather than client trading flow to infer information, their trading performance becomes indistinguishable from the performance of a naive strategy that internalises noise flow, externalises informed flow, and offloads inventory at a constant rate.