Block Ownership, Trading Activity, and Market Liquidity

Abstract

We examine the impact of block ownership on the firm s market liquidity. These adverse liquidity effects disappear, however, once we control for trading activity. Our findings suggest that block ownership is detrimental to the firm a real friction effect. After controlling for this real friction effect, we find little evidence that block ownership has a negative impact on informational friction. Our results suggest that the relative lack of trading, and not the threat of informed trading, explains the inverse relation between block ownership and market liquidity.

Full text

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Electronic copy available at: http://ssrn.com/abstract=1117285

Block Ownership, Trading Activity, and Market Liquidity




Paul Brockman
Department of Finance
513 Cornell Hall
University of Missouri – Columbia
Columbia, MO 65211-2600
Tel: (573) 884-1562
Email: BrockmanP@missouri.edu


Dennis Y. Chung
Department of Accounting
Simon Fraser University
Burnaby, BC V5A1S6
Tel: (778) 782-4355
Email: DYChung@sfu.ca


Xuemin (Sterling) Yan
Department of Finance
427 Cornell Hall
University of Missouri – Columbia
Columbia, MO 65211-2600
Tel: (573) 884-9708
Email: YanX@missouri.edu





This Draft: March 2008






_______________________________

* We would like to thank Hendrik Bessembinder (the editor), John Howe, Sandra Mortal, Andy
Puckett, two anonymous referees, and seminar participants at the University of Missouri –
Columbia for helpful comments.

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Electronic copy available at: http://ssrn.com/abstract=1117285
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Block Ownership, Trading Activity, and Market Liquidity




Abstract

We examine the impact of block ownership on the firm’s trading activity and
secondary-market liquidity. Our empirical results show that block ownership takes
potential trading activity off the table relative to a diffuse ownership structure and
impairs the firm’s market liquidity. These adverse liquidity effects disappear, however,
once we control for trading activity. Our findings suggest that block ownership is
detrimental to the firm’s market liquidity because of its adverse impact on trading
activity – a real friction effect. After controlling for this real friction effect, we find
little evidence that block ownership has a negative impact on informational friction.
Our results suggest that the relative lack of trading, and not the threat of informed
trading, explains the inverse relation between block ownership and market liquidity.



JEL Codes: G10; G32
Keywords: Block ownership; liquidity; bid-ask spreads; depths; adverse selection

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I. Introduction
Block ownership plays an increasingly important role in US capital markets. Dlugosz,
Fahlenbrach, Gompers, and Metrick (DFGM) (2006) find that block ownership increased from
21.7 percent of outstanding shares in 1996 to 25 percent in 2001 in their sample of over 1,900
relatively large firms.1 Given the pervasiveness of block ownership, it is important to understand
the role that blockholders play in such areas as firm valuation, corporate decision-making, and
secondary-market liquidity. Several previous studies have investigated the effect of block
ownership on firm valuation and corporate decision-making (e.g., Stulz (1988), Demsetz and
Lehn (1985), Morck, Shleifer, and Vishney (1988), Kole (1995)).2 In contrast, few studies to
date have examined the impact of block ownership on the firm’s market liquidity.3 The purpose
of this paper is to help fill this void by examining the real and informational friction effects of
block ownership.
There are two primary mechanisms through which block ownership can affect the firm’s
secondary-market liquidity: altering the firm’s trading activity or changing its information
environment. Stoll (2000) refers to the first mechanism as a real friction effect, and to the
second mechanism as an informational friction effect. Real friction is defined as “the real
resources used up” in the liquidity-provision process. These order processing and inventory
costs are highly sensitive to trading activity levels. Previous empirical research has shown that
trading volume is negatively related to bid-ask spreads (Benston and Hagerman (1974), Stoll
(2000)) and positively related to depths (Brockman and Chung (1999)). Therefore, block
ownership could affect the real friction component of liquidity by altering the firm’s trading
activity relative to a diffusely-owned firm. In particular, if blockholders trade significantly less

1 We follow prior literature to define blockholders as shareholders who hold five percent or more of a firm’s shares.
2 See Holderness (2003) for a review of the block ownership literature.
3 As discussed below, Heflin and Shaw (2000) is an exception.

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than non-blockholders, the reduction in trading activity will increase real friction costs by
spreading fixed real costs over fewer trades.
The second mechanism through which block ownership can affect the firm’s market
liquidity is informational friction.4 Instead of reflecting the real costs of liquidity provision,
informational friction reflects the potential losses of trading against informed traders. Previous
research has shown that market makers widen bid-ask spreads and reduce depths in the presence
of informed traders (Copeland and Galai (1983), Kyle (1985), Glosten and Milgrom (1985)).
The impact of blockholders on the informational friction component of liquidity depends on their
proclivity to use private information while trading against the uninformed. If blockholders
(relative to non-blockholders) frequently trade on private information, then block ownership will
adversely affect market liquidity by increasing informational friction costs. On the other hand, if
legal, regulatory, or internal governance concerns effectively restrict such informed trading, then
block ownership will not adversely affect informational friction costs.
It is important to distinguish between real and informational friction effects because of
their direct implications for asset pricing, corporate governance, and regulation.5 With respect to
asset pricing, real friction will lead to lower prices and higher expected returns to offset the real
costs of trading (Stoll (2000), Amihud (2002)). The impact of informational friction on asset

4 The degree to which aggregate or specific types of blockholders are informed traders is an open empirical question.
Most of the literature dealing with block ownership and stock market returns focuses on the operational and
monitoring aspects of block ownership. Barclay and Holderness (1991) and Bethel, Liebeskind, and Opler (1998)
find abnormally positive returns associated with blockholder purchases. However, both studies reject the idea that
these positive returns are mostly due to superior information. Studies that focus on specific types of blockholders,
including institutions and insiders, have also yielded rather weak results. Bartov, Radhakrishnan, and Krinsky
(2000, p. 43) show that their “tests evaluating the validity of institutional holdings as a proxy for investor
sophistication yield only mixed results.” Bushee and Goodman (2007) find that changes in institutional ownership
are consistent with trading on private information. Perhaps the strongest evidence that some blockholders trade on
superior information comes from studies of insider trading. But even here, Lakonishok and Lee (2001) show that
insider trading abilities are limited to purchases (not sales) of relatively small companies.
5More generally, there is an important causal link between market liquidity and cost of capital (Amihud and
Mendelson (1986), Brennan and Subrahmanyam (1996), Datar, Naik, and Radcliffe (1998), and Easley, Hvidkjaer,
and O’Hara (2002)). Block ownership can indirectly affect the firm’s cost of capital through its impact on liquidity.

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prices is less clear since informational friction mainly affects the distribution of wealth between
informed and uninformed investors (Stoll (2000)). With respect to corporate governance and
regulation, evidence of higher informational friction suggests that blockholders not only possess
superior information, but actively trade on it to the detriment of uninformed investors. In
contrast to real frictions, informational frictions could be reduced through stricter corporate
governance and regulatory provisions.
There is little consensus on the relative importance of real and informational frictions in
general, and even less consensus on the block ownership-liquidity relation. At least part of the
difficulty has to do with measurement. In this study, we follow Stoll’s (2000) suggestion that
informational friction can be thought of as (p. 1510) “the difference between total friction (such
as the quoted or effective spread) and real friction.” We disentangle real and informational
effects by first examining the impact of block ownership on the real costs of trading. These real
friction effects are directly related to the firm’s trading activity level (e.g., volume, turnover,
number of trades, trade sizes). After measuring the real friction effects, we then examine the
impact of block ownership on the firm’s market liquidity (e.g., spreads, depths, adverse
selection, price impact) while controlling for the known real friction effects.
Previous empirical studies that investigate block ownership often suffer from biased or
insufficient data. DFGM (2006) show that the widely-available Compact Disclosure database
contains a large number of mistakes that can lead to a significant overstatement in the level of
reported block ownership. One can avoid these Compact Disclosure biases by hand-collecting
block ownership data from source documents. This alternative, however, leads to a relatively
small number of observations and works against standardization and comparability across
studies. In addition, Chordia, Roll, and Subrahmanyam (2001) stress the importance of