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Using proprietary audit trail transaction data compiled by the Commodity Futures Trading Commission, we investigate at the individual trader level (1) the timing and (2) the determinants of dual traders’ personal trades. Our analysis reveals an absence of any trade timing by dual traders in relation to the execution of their customers’ orders. Further examination employing correlation statistics and time series regressions provides strong support for the proposition that dual traders supply liquidity and actively manage inventory. Even after simultaneously controlling for factors representing information, liquidity supply, and inventory control, within a multivariate regression framework, liquidity supply and inventory control remain as the determinants of dual traders’ personal trades. Overall, the emergent profile of a dual trader is that of an uninformed trader performing complimentary tasks.

Dual trading is an age-old custom in futures markets whereby some floor traders are allowed to trade both for themselves and for their customers. The Chicago Mercantile Exchange Rulebook defines dual trading as: The term “dual trading” shall mean trading or placing an order for one's own account, an account in which one has a direct or indirect financial interest or an account which one controls, in any contract month in which such person previously executed, received or processed a customer order on the Exchange floor during the same Regular Trading Hours session. This seemingly innocuous practice has attracted the attention of researchers and regulators alike, in light of ongoing Congressional debate on imposing personal trading restrictions on dual traders. An excerpt from Bloomberg news wire release, July 22, 1999, titled “Regulators to Decide Personal Trading by Futures Brokers” reads, in part, as follows: U.S. regulators are gearing up to decide soon whether to limit a common trading practice on futures exchanges in Chicago that some critics say raises the potential for brokers to cheat their customers. …… “We will lose some of our brokers, who say they need to supplement their income by trading for themselves as well as their customers [If these trading limits are imposed],” said Jim Sutter, who manages Cargill Inc.'s oilseeds and grain futures trading on the Exchange. The supporters of the ban on dual trading argue that floor traders are in a position to front run their customers' orders. An FBI sting operation at the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) in late 1988 and early 1989 concluded that brokers (including dual traders) were cheating customers. This operation led to dozens of arrests and a 1992 government ban on dual trading in major futures contracts. Interestingly, Congress banned the practice of dual trading but then left the door open by telling regulators they could decide on when to enforce the ban. Opponents of the ban claim (see Grossman, 1989) that some brokers affected by the ban might exit the market, resulting in illiquid markets and higher trading costs for investors. The debate ultimately boils down to whether dual traders should be allowed to enjoy the privilege of own account trading along with their normal brokering activities. We contribute to this debate by investigating two related questions not addressed by the extant empirical literature. Specifically, we examine (1) the timing of a dual trader's personal trades in relation to the execution of a customer's orders and (2) the determinants of his personal trading decision. Existing research suggests the possible candidates driving dual traders’ personal trading are information, liquidity supply, and inventory control. 1 Trade-timing issues are not addressed in the dual trading literature (possibly due to the paucity of appropriate data) while an analysis of the determinants of a dual trader's personal trading decision, within a multivariate regression framework, is also absent. The literature largely examines the correlation between trade-related characteristics and each of the above-mentioned factors, in isolation of the others, for a cross-section of dual traders. The CME definition of dual trading, coupled with the results of existing research, provide testable implications related to information, liquidity supply, and inventory control in terms of the timing/direction of dual traders’ personal trades vis-à-vis the execution of their customers’ orders. Thus, for example, dual traders could become informed after observing their customers’ orders and/or by knowing something about their customers’ motives for trading. They could then take advantage of this information by trading on their own account either ahead of or following the execution of their customers’ orders. Consequently, a simple test of whether dual traders are informed traders is to examine the existence (and direction) of causality between a dual trader's personal trades and his customers’ trades. Similarly, a test of the liquidity-supplying role of dual traders is to investigate whether their own account trades are always in opposite direction of their customers’ trades. Finally, a test of the inventory-rebalancing hypothesis examines if dual traders’ own account trading make their inventory revert rapidly to a constant level (i.e., if their inventory is mean-reverting). Our data are time series of audit trails at the CME during the first half of 1992 compiled by the Commodity Futures Trading Commission (CFTC) providing information on trade time, price, quantity, trade direction (buyer or seller), and the trader's identification. They are used internally by the CFTC for regulation and enforcement purposes. On performing tests of causality (Granger, 1980), on a trader-by-trader basis, we find an absence of dual traders’ personal volume either causing their customers’ volume or vice versa. This result survives a battery of robustness checks performed on various partitions of the data. We also test for, and reject, the possibility of inter-dealer collusion with regard to front-running and piggy-backing. In the spirit of the CFTC's original inquiry into the fraudulent practices at the CME in 1989 (see, for example, CFTC, 1989), we investigate the direction of a dual trader's personal trades in relation to his customers’ trades and find that there is significant negative correlation between dual traders’ own account trades and those of their customers. Thus, dual traders appear to be liquidity suppliers. Our tests further reveal that dual traders are significant liquidity providers during times of large price swings and when other liquidity suppliers (such as locals) 2 are in short supply. They can also have a more important liquidity-providing role in relatively lower-volume futures pits. In addition, we find strong evidence of rapid mean-reversion in the personal inventory of individual dual traders in our sample. Finally, we examine the determinants of a dual trader's decision to trade for his own account, after simultaneously controlling for information, liquidity supply, inventory control behavior, and other factors considered relevant by the extant literature. We find that liquidity supply and inventory control factors determine a dual trader's decision to trade for his personal account. The result that dual traders both provide liquidity and control personal inventory is, in essence, opposite sides of the same coin. One requires a dual trader to move away from a desired inventory position (through liquidity supply), the other fuels the need to revert back toward a desired inventory position (through inventory control).3 Our results call into question the notion that dual traders are informed traders capable of misusing their information for private gain. This can assuage the concerns of regulators when determining the prevalence and/or the seriousness of such offenses. Our research builds on the work of Fishman and Longstaff (1992, henceforth FL) who developed a dual trading model based on the assumption that a broker has imperfect, though better, information (relative to other floor traders) about whether his customer is making an informed or an uninformed trade. Upon testing the implications of their model with transaction data similar to ours, FL find that the personal trading profits of dual trading brokers are significantly higher than those of other floor traders; the personal trading profit of a given floor trader is higher on days when he is dual trading than on other days; and the customers of dual trading brokers earn higher profits than the customers of non-dual trading brokers. From these results, FL infer that dual traders are informed traders and that the higher trading profits of dual traders are due to the information conveyed by their customers’ orders rather than to dual traders’ superior trading skills. Our study differs from FL in several ways that may account for the differences in findings. First, we provide a trader-by-trader examination of the trading behavior of dual traders vis-à-vis the execution of their customers’ orders. Second, while FL study a single contract, soybean, over 15 randomly selected days, we study a wide variety of contracts over a six-month period. Third, the soybean contract examined in FL trades at the Chicago Board of Trade, while our contracts trade at the CME. Finally, the sample period in FL pre-dates the FBI sting operation in 1989, while our study is conducted on contracts traded well after the FBI investigation. The remainder of the paper is organized as follows. Section 2 reviews the related literature while Section 3 discusses the data. Section 4 examines the direction of causality between dual traders’ personal trades and their customers’ trades, using a trader-by-trader approach. Section 5 examines the liquidity-providing role of dual traders, while Section 6 investigates dual traders’ inventory management practice. Section 7 examines the determinants of dual traders’ personal trades under a multivariate regression framework. Section 8 concludes. An Appendix detailing the dual traders used in the analyses is omitted for brevity, but is available on request.

Using detailed and proprietary audit trail transaction data compiled by the CFTC, we seek to investigate, at the individual trader level, the timing of dual traders’ personal trades relative to the execution of their customers’ orders and the determinants of their personal trades. Our analysis reveals a surprising absence of any trade timing by dual traders vis-"a-vis the execution of their customers’ orders. Further examination employing correlation statistics and time series regressions provides strong support for dual traders as liquidity suppliers and for their inventory control behavior. We also perform individual trader-by-trader regressions of own account trading on factors representing information, liquidity supply, and inventory rebalancing and find that the main reasons for own account trading by dual traders are liquidity supply and inventory rebalancing. Our research extends the seminal work of Fishman and Longstaff (1992) who find evidence consistent with dual traders being informed traders. While our results differ from theirs, the divergence in results can be reasonably ascribed to major differences in the data and time periods over which the two investigations are carried out. FL’s investigation is based on an actively traded contract listed at the CBOT over a period just before the FBI launched a Federal investigation into fraudulent trading practices at Chicago futures exchanges. Ours is based on futures contracts of varying trading activities listed at the CME over an extended period after the FBI operation. The current investigation follows on the heels of a renewed legislative interest in whether to curb, and ultimately to ban, the privilege enjoyed by dual traders in the futures markets both to trade on their personal account and to execute their customers’ orders. A central argument for banning dual trading is that dual traders are informed traders, front running their customers’ orders for private gain. We find no evidence to support such claims. In fact, the emergent profile of a dual trader is that of an uninformed trader trading primarily for liquidity provision and inventory rebalancing. Regulators will, therefore, need to proceed with caution before implementing any restrictions on own account trading by dual traders.