Institutional Trading, Trading Volume, and Spread

Abstract

The effect of institutional trading on the bid-ask spread is of interest to regulators and market makers. It is often (casually) argued that greater institutional participation results in increased volatility in the market. On the other hand, some argue that greater liquidity trading by institutions should reduce spread. There has been no direct empirical evidence or theoretical knowledge to suggest a relation between institutional trading and spread. In this paper, we present a clearer picture of the nature and effect of institutional trading on spreads. We show that institutional trading is not always information driven, part of it is liquidity trading in nature. Information induced trading increases the adverse selection component. However, large volume (liquidity) trading reduces the order processing costs. Moreover, institutional buys have differential information from sells. Buys reduce spreads, while sells increase the adverse selection component. The effective spread impounds the differential nature of their trading.