Eduardo Dávila, Cecilia Parlatore,
Based on: The Journal of Finance, 2022, 76: 1471-1539 DOI: https://doi.org/10.1111/jofi.13008
In recent years, advancements in technology have made trading in financial markets significantly cheaper, allowing investors to trade securities with little to no fees. This has resulted in a surge of participation in the stock market, arguably democratizing stock trading. Even unqualified investors can now buy and sell assets at their discretion through e-trading platforms such as E-trade and Robinhood. However, this increase in non-expert, uninformed traders has the potential to interfere with one of the central roles of financial markets: aggregating information dispersed in the economy.
This negative potential effect of cheap trading on market efficiency has been the basis of a long-standing argument among the proponents of financial transaction (Tobin) taxes. Along these lines, supporters of Tobin taxes argue that higher transaction taxes would curb excessive volatility resulting from speculative trading. On the other side, those who oppose the adoption of Tobin taxes argue that higher cost of trading can discourage informed trades and reduce price informativeness, ultimately harming market efficiency. So, who is right in this debate? Do both sides have a valid point? How do trading costs affect market efficiency?
The answer to these questions hinges on who trades in the market. While cheaper trading increases trading by all investors, whether more volume improves market efficiency depends on who is trading more and what is driving these trades in the first place. For example, if an investor revises his forecast about a firm’s performance after carefully analyzing the firm’s business plans, his expertly informed trades will contain information about the fundamental value of the firm and move the price closer to it. However, if the investor bases his trades solely on social sentiment, as is the case with many meme stock traders, his trades will likely be unrelated to any real activity performed by the firm and will mostly add noise to the price, hindering the ability of the price to reveal the fundamental value of the stock.
More broadly, an increase in volume driven by informed trades has implications for market efficiency very different from those implied by the same increase coming from investors trading based on sentiment, hedging needs, or liquidity needs. Therefore, whether lower trading costs increase the informativeness of prices depends on whether the information-based trades increase more than noise-based ones. As a baseline, consider the case in which the amounts of information and noise-based trades increase proportionally. In this case, the signal-to-noise ratio and the informativeness of prices remain unchanged. This useful benchmark applies to markets in which investors are similar to each other.
However, in practice, many different types of investors coincide in the same market. For instance, institutional investors coexist with retail investors. Institutional investors are better informed than retail investors and contribute more to the informational content of prices. At the same time, the demand of institutional investors is more sensitive to trading costs because they have a higher risk tolerance and face lower uncertainty about the asset payoff. Hence, a reduction in trading costs disproportionately increases the share of informed trades (by institutional investors) and increases price informativeness.
In contrast, in markets with a prevalent population of speculators, a decrease in trading costs decreases price informativeness. Speculators are generally overconfident investors who base their trades on hunches and sentiment rather than on information. Hence, a decrease in trading costs disproportionately decreases the share of informed trades and decreases market efficiency.
These examples illustrate that the type of investors in the market and the distribution of information among them play a pivotal role in determining the impact of trading costs on market efficiency. While the distribution of information across investors remains relatively static in the short run, investors can adapt their information-gathering technologies over the long term.
In situations in which investors exhibit similar characteristics, a reduction in trading costs doesn’t directly affect price informativeness. However, reduced trading costs do increase the value of acquiring additional information, so the long-term effect of lower trading costs is greater information acquisition. As a result, lower trading costs indirectly increase price informativeness, via the channel of information of acquisition. This predicted chain of events is consistent with three important trends over the last 50 years: reduced trading costs, increased price informativeness, and the increasing importance of financial trading as a share of gross domestic product.
In summary, the reduction in trading costs has thrown open the gates of the stock market, inviting an ever-growing pool of investors to dive in. In the short run, whether this democratization of the stock market improves market efficiency depends on the change in the share of non-expert and uninformed trades relative to those of their informed counterpart. However, the long-term effect of a reduction in trading costs is likely to increase the amount of information acquired by market participants, leading to an increase in the signal-to-noise ratio in the price and improving market efficiency. But whether this development is good or bad depends on whether traders acquire too much or too little information to begin with, which is an unresolved question in financial economics.