Transaction Costs and Market Efficiency

Previous research suggests that a decline in transactions costs leads to improved economic efficiency. In this paper, we show that such a decline will introduce increasingly uninformed consumers into established markets. Using a model of financial market inefficiency, we show that this increase in uninformed individuals can increase market risk (volatility), can decrease efficiency, and may reduce social welfare even when market participants are perfectly rational. We then test the predictions of our model using data on the retail equities market. Our results suggest that securities that have a large proportion of small trades (presumably disproportionately from small, online retail investors) tend to be less efficient by conventional measures, consistent with our model predictions. Keywords: eCommerce, transaction costs, market efficiency. INTRODUCTION The effects of a decline on transactions costs on the structure and performance of organizations and markets has been a central theme in the information systems literature for many years (Gurbaxani and Whang 1991; Malone et al. 1987). For the most part, research on this topic suggests that lower transactions costs are almost always beneficial. Reductions in transactions costs have been linked to direct cost savings, indirect benefits through improvements in agency costs, monitoring or coordination within existing organizations and markets, and even the creation of new types of market structures that are more efficient (Clemons and Row 1992; Malone and Rockart 1991). A few studies have considered negative effects of reduced transactions costs, especially on intermediaries, but even here the replacement of traditional intermediaries with electronic interaction is socially beneficial, even if it reduces the profitability of existing intermediaries (Clemons and Weber 1994). However, not all reductions in transactions costs need be beneficial. For instance, classic economic problems such as the “lemons problem” (Akerlof 1973) can be exacerbated if lower transactions costs lead some participants to become more informed than others. Alternatively, reduced transactions costs may introduce new, poorly informed participants into markets that they would otherwise access through a professional intermediary who would screen or temper their information disadvantages. To the extent that market efficiency is affected by the introduction of less uninformed participants, a reduction in transactions costs can impede market efficiency and create real social costs. Gu & Hitt/Transaction Costs and Market Efficiency In addition to financial markets, these concepts apply generally to auction markets, markets with imperfect price discrimination mechanisms, or those with participation externalities. Detailed discussions can be found in Delong et al. (1990) and in Lee et al. (1991). 86 2001 — Twenty-Second International Conference on Information Systems While this problem is quite general in any market where a consumer’s price is affected by other consumers’ information sets, it is potentially of greatest importance in financial markets, especially in the retail equities markets. For as low as $5 per trade, anyone can trade stock using a web browser—a cost reduction of as much as a factor of 150 from full service brokerage rates, and perhaps a factor of 30 from traditional discount brokerage rates. With the growth of on-line brokerage (currently at about 29 million accounts—Credit Suisse First Boston 2001) there has been an even greater proliferation of online financial information services ranging from investor chat (e.g., RagingBull.com) to sophisticated analytics for options and derivatives. The combination of plentiful investment information and easy access to trading services has created a “trading boom” among small, retail investors. While more information may make retail investors better informed, retail investors still have a strong information disadvantage relative to market professionals and may show “overconfidence,” causing them to make worse trading decisions (Barber and Odeon 2001). Studies show that investors with access to online trading trade more frequently (Choi et al. 2001) with lower total returns (Barber and Odean 2001) than investors who lack online access. However, the impact of these investors on market efficiency has not been previously addressed. Economists have long believed that irrational or less informed investors (“noise traders”) have no impact on asset prices and, therefore, will have no effect on market efficiency. Fama (1965) argued that “sophisticated investors … will trade against [less informed] ones and drive prices close to intrinsic values.” Moreover, in the course of such trading, the less informed investors will lose money and eventually be weeded from the market. However, these arguments depend critically on the assumption that informed investors can fully arbitrage against the noise traders, which, as Black (1986) pointed out, only holds when the informed investors have unlimited financial resources and infinite time horizons. In real financial markets, there are at least two factors that limit informed investors’ arbitrage behavior (see Delong et al. 1990; Lee et al. 1991). First, many market professionals are measured and compensated on short run performance in managing a finite portfolio. As a result, they may be unwilling to engage in arbitrage requiring significant time or open-ended financial commitments. For instance, at the peak of the stock market a few years ago, CNBC interviewed a number of experienced mutual fund managers. Almost all of them agreed that eCommerce stocks were significantly over-valued, but none of them were willing to short sell these stocks for fear that they could rise further for a long period before falling back to the intrinsic value. For managers measured by quarterly performance, the risks were simply too high to justify the arbitrage. Second, because shortselling shares is subject to different costs, margin requirements, and regulatory restrictions than taking long positions (buying shares), this deters managers from taking short positions even when they believe shares are overvalued. Based on these intuitions, DeLong et al. (1990) developed a model demonstrating that “arbitrage does not eliminate the effect of noise because noise itself creates risk [under finite time horizons]” (emphasis in original). As a result, the assets become less attractive to informed investors and prices become lower. Thus, both noise traders and informed investors will expect higher returns and higher risks (volatility) in this market. We consider the effects of declining transactions costs on the performance of financial and other information intensive markets. In the first part of the paper, we develop a simple model that links declining transactions costs to an increase in direct market participation by less informed investors (who no longer have intermediaries to compensate for their information disadvantages). This model also shows a decline in margins for intermediaries. While this is intuitive, the model is interesting because it generates these results with few assumptions. Then, building on the model developed by DeLong et al., we consider the problem that an increase in participation by uninformed investors creates on overall market efficiency. This model generates a specific set of testable predictions that we examine using data on the price behavior of recent initial public offerings (IPOs), a set of stocks that is particularly favored by online traders. While our empirical measures of various model constructs are far from perfect, we do find evidence that stocks heavily traded by in small lots (presumably by retail investors, especially those online) tend to show greater violations of standard indicators of market efficiency. Our work is related to research on market price variance and flows of market information (Barclay et al. 1990; Charles et al. 1994), but differs in that we consider the impact of changing the balance of informed and uninformed investors rather than the effects of the arrival of new information. It differs from classical transaction cost approaches in that it incorporates the issue of market efficiency in addition to market structure. Our work is most closely related to research on market inefficiency, although we propose a specific process by which uninformed investors are introduced into the market. Gu & Hitt/Transaction Costs and Market Efficiency While the model is built for a monopolistic agent, results are qualitatively similar as long as competition is imperfect. The hazard function of distribution F(θ) is: f(θ)/[1 – F(θ)]. This is because under CARA utility and normally distributed wealth, expected utility has the form E(U(w)) = E(e) = :w – (Fw where the mean and variance of w are given by ( :w , Fw). 2001 — Twenty-Second International Conference on Information Systems 87 MODEL Model: Intermediary Fees and Investor Participation We consider a market with products of uncertain values with two types of market participants: individuals and a monopolistic professional agent. An individual can either access the market directly (incurring a transaction cost) or can use the agent by paying a fixed fee. Agents are risk neutral, face zero transactions costs, and have perfect information regarding the value of the underlying good (a probability distribution). Individuals are risk-averse, face positive transaction costs, and have worse information regarding valuation of the available assets than the agent (in the form of a mean-preserving spread of the true distribution). Formally, we make the following assumptions: 1. The true value V of the product is normally distributed with mean θ and variance σ2θ. For individual i, a noise of εi ∼ N(0, σι) is mixed in the perceived information of the value. The exact value of σ 2 ι is private information to the individual (i), while the distribution of σι, F