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									Introduction and Market
  Microstructure Data
   Prof. Ingrid M. Werner
         Spring 2004
    What is market microstructure?
• Traditional asset pricing aims to understand what should
  be the price of a security. It does not, however, address
  how prices adjust to reflect news nor does it explain how
  investors’ subjective assessment of a security “get into” the
  price.
• In practice, news and investors’ valuations are
  incorporated into security prices through trading.
• This means that the specific trading rules, and the
  strategies traders develop in response to these rules, will
  affect how asset prices change over time in response to
  new information.
   What is Market Microstructure?
• Maureen O’Hara:
  “Market microstructure is the study of the process
  and outcomes of exchanging assets under explicit
  trading rules.”
• It is one of the most rapidly growing areas in
  Finance.
• It has a profound impact on the real world – on
  traders, broker/dealers, exchanges, regulators, and
  policy makers alike.
  Vignette WFA Sunriver, OR, 1996
• Distinguished speaker Prof. Joseph Williams UBC
   “The problem with Finance is that we have lost touch with the
   business world and the needs of those who are supposed to apply our
   theories.”

• Comment by Prof. Maureen O’Hara, Cornell
   “He obviously does not follow the field of market microstructure…”

• Market microstructure is probably the area in Finance with the closest
  ties to practice.
• Conferences draw a steady crowd of practitioners, regulators, lawyers,
  and computer scientist who pay “exorbitant” conference fees to hear
  academics present thei research findings!!!
                       Cheerleaders
• Market centers have made transactions data available to
  researchers
   – Equities:
       • NYSE, Nasdaq, Regionals, Island (INET)
       • Paris Bourse, London Stock Exchange, Toronto Stock Exchange,
         Tokyo Stock Exchange, Hong Kong Stock Exchange, Korea Stock
         Exchange, …
   – Derivatives:
       • CBOE, ISE, CME, etc.
   – Bonds:
       • GovPX
   – Exchange Rates:
       • Ohlsen Associates, Reuters
                         Cheerleaders
• Market centers have also provided generous research
  support.
   – NYSE Visiting Academic Fellow
        • Paul Bennett
   – NYSE Day on the Floor Program
   – Nasdaq Visiting Research Economists
        • Frank Hatheway and Tim McCormick
   –   Tailored datasets
   –   Proprietary data
   –   Commissioned studies
   –   Conferences…
          Regulators actually listen!
• Believe it or not, this is a field where the regulators
  actually listen to the advise of academics!
   –   Manning Rules (1994, 1995)
   –   Concept Release (1999, Richard Lindsey)
   –   Regulation ATS (1999)
   –   Decimalization (2000-2001, Larry Harris)
   –   Rule 11Ac1-5, Rule 11Ac1-6 (2001, Mark Ready)
   –   Regulation NMS (2004, Larry Harris)
   –   Public Comment
   –   Round table discussions
                 Why do they care?
• Data guided by theory, Theory guided by data
• Efficiency – welfare issues
   – Is insider trading bad?
• Market design issues
   – Agency auction market
   – Dealer market
   – Electronic limit order books
• Market performance issues
   – Transaction costs
   – Shock absorption/resiliency
   – Trading halts
• Competition for order flow
• Industrial organization
            What is in it for me?
• Given the amount of research in the area, it still
  surprises me how limited our knowledge is of
  different market structures.
• This is good news!!!
• There is plenty of room for more research!!!
• This course will cover only the basics.
• I will try to point you in the direction of fruitful
  areas for research as we go along.
                    Who am I?
• Instructor:Prof. Ingrid M. Werner
   – At OSU since 1998
   – Prior to that, at Stanford Business School (1990-1998)
   – PhD economics from University of Rochester (1990)
     and MBA from Stockholm School of Economics (1984)
   – Visited NYSE 1997
   – Visited Nasdaq 2001-2002
                  Course Topics
•   Introduction and market microstructure data.
•   Market making and inventory control
•   Asymmetric information and strategic trading
•   Block trades and institutional trading costs
•   Limit order books and order submission strategies
•   Estimating structural microstructure models (PIN),
    modeling irregularly spaced data (ACD), linking
    microstructure to asset pricing, event studies, etc.
                Empirical Projects
• Project I
   – Inventory control
   – Data from the London Stock Exchange
• Project II
   – Intraday patterns and trading costs
   – Data from the NYSE and Nasdaq (TAQ)
• Project III
   – Order submission strategies
   – Data from the Paris Bourse
             Major trading issues
•   Liquidity
•   Transaction Costs
•   Informative Prices
•   Volatility
•   Trading Profits
Forces affecting the structure of markets
• Demand for trading
   – Liquidity trading
   – Information trading
   – Noise trading (Black (1991))
• Order processing costs
   –   Information system
   –   Order routing systems (e.g., SuperDOT)
   –   Order execution system (e.g., SuperMontage)
   –   Clearing and Settlement
Forces affecting the structure of markets
• Technology and automated trading
   – Resistance/vested interests (e.g., NYSE floor
     community!)
   – Block traders
• Risk bearing
   – Inventory risk
   – Payments risk
• Institutionalization
   – 50% of volume is institutional traders
Forces affecting the structure of markets
• Free trading options
   – Stale limit orders
   – Stale quotes
• Information trading
   – Liquidity traders lose
   – Informed traders need to be compensated for research
• Anonymity, Reputation, Transparency
   –   Disclosure of trades and quotes
   –   Delayed disclosure
   –   Upstairs facilitated trade
   –   Reputation through repeated trading
Players
  Two sides of the trading industry
• People and institutions who use market services
  are on the buy-side.
• Those who provide market services are on the sell-
  side.
• These sides have nothing to do with whether you
  are a buyer or seller of a specific security.
       Buy-side players - Investors
• Individuals           • Investment managers
• Corporate pension     • Corporate investment
  fund sponsors           funds
• Charitable trusts     • Insurance reserve
• Legal trusts            funds
• Endowments            • Governmental funds

  => Stocks and Bonds
    Buy-side players – Borrowers and
                Hedgers
• Homeoweners            •   Farmers
• Students               •   Manufacturers
• Corporations           •   Miners
                         •   Shippers
  => Mortgages, Bonds,
  Notes                  •   Financial Institutions

                             => Forwards, Futures,
                             Swaps, and Options
              Sell-side players
• Dealers trade for their own accounts.
   – Day Traders
   – Scalpers
   – “Locals”
• Brokers trade for other people’s accounts.
   – Retail and institutional
   – Full-service and discount
• Broker-dealers do both.
   – Specialists
   – Wire houses
         Sell-side trade facilitators
• Exchanges provide systems that help traders
  arrange their trades.
   – Note that exchanges and brokers often compete with
     each other.
• Clearing firms clear and settle trades
   – E.g., Bear Sterns.
• Clearing houses help settle trades and guarantee
  that traders will perform.
• Depositories and custodians hold securities.
       A typical set of relationships
•   A sponsor owns funds.
•   An investment manager makes portfolio decisions.
•   A broker implements trade decisions.
•   A dealer supplies liquidity.
•   A clearing house guarantees the trade.
•   A depository holds the security.
•   Consultants advise everyone.
The Market Centers
        US primary listing market
•   New York Stock Exchange   (N)
•   American Stock Exchange   (A)
•   Nasdaq                    (Q)
•   Over-the-Counter (OTC)
    – Nasdaq small cap        (S)
    – OTCBB                   (U)
    – Pink Sheets
          US regional exchanges
• Pacific Exchange / Archipelago   (P)
• Chicago (formerly Midwestern)
  Stock Exchange                   (M)
• Boston Stock Exchange            (B)
• Philadelphia Stock Exchange      (X)
• Cincinnati Stock Exchange        (C)
                     Third markets
• OTC Dealers (Madoff, Knight/Trimark)       (T)
• Jefferies, Jones & Co, Cantor Fitzgerald
• ECN’s (Proprietary trading systems)
   –   Instinet
   –   Island
   –   Archipelago
   –   Posit
   –   The Crossing Network
   –   Bloomberg B-Trade
   –   Liquidnet
   –   Harborside
SEC                     The market for Nasdaq stocks today
         public investors
                                                              broker-dealers



                                      10 ECNs                        NASD broker dealers   non U.S.
          Posit           Instinet                    ARCA
                                                                                           markets
           Crossing             Merging Island
           Network
                                                        NASDAQ
                                                      SuperMontage
         Liquidnet              Amex

                    PHLX                  CHX
                                 CSE
      direct access                                                      U.S. markets


 Source: Goldman Sachs, Trading & Market Structure Analysis
              Volume distribution – Nasdaq stocks
                                                                                                   Share volume
                                                                     Nasdaq SM                     Single-counted
October 2003                                        Liquidnet           17%                        Internal matches only
                                                                                                   All hours
                                                      0.1%
                                                                                                   Excluding ETFs

 Mostly broker-dealer                                  Distribution
 upstairs trades                                   by Execution Venue
 But also small activity on:                                                                      ARCA
                                                                                                   25%
 • Brut (also in SM)                       Other
 • NexTrade (also in SM)                   33.4%
 • MarketXT (also in SM)                                                                                         Nasdaq
                             2 to 5 percent?                                                                       SM
 • Attain (also in SM)                                                                                            17%
 • TradeBook (also in SM)                                                                          Distribution
 • Other ATSs                                                                                     by Print Venue                  ARCA
                                                                                                                                   25%

                                                         Posit                                     Nasdaq
                                                         0.5%                                       Other
                                                                                 Instinet &
                                                           Chicago                                  30%
                                                                                   Island
                                                              1%                    23%                     ADF           CINCI
                                                                                                               CHICAGO
 Source: Goldman Sachs, Trading & Market Structure Analysis                                                 6%            21%
                                                                                                                 1%
SEC                        The market for NYSE stocks today
         public investors
                                                        broker-dealers

                                                                      Knight
                       Instinet                                           Madoff

                                   10 ECNs             NASD broker dealers           non U.S.
              Posit
                                                                                     markets
               Crossing                     ARC                CHX
                                                                      U.S. markets
               Network
             Liquidnet                                               PHLX
                                                                             ITS
      direct access
                 HarborSide                            NYSE           CSE

                      Millennium
                                                                     BSE



 Source: Goldman Sachs, Trading & Market Structure Analysis
     Volume distribution - NYSE stocks
         12%
                               October 2003                                                    Single-counted,
                                                                                                share volume
                                                                     Other                     Internal matches only
                                                                   exchanges                   All hours
                                                              Chicago 3%
                                                                                               Excluding ETFs
                                                                4%
                                                           ARCA
                        Seeing through                      1%
                      Nasdaq InterMarket

                                                 Nasdaq
                                   2%          InterMarket
                      1%                           15%
0%
                                                                                                              NYSE
     Broker-dealers   Posit     Other ECNs                                                                    77%
                                 and ATSs




                                        Source: Goldman Sachs Trading & Market Structure Analysis
  Major international stock markets
• Europe;
   –   London Stock Exchange (LSE)
   –   EuroNext (Paris/Netherlands/Belgium)
   –   Deutsche Borse (DB)
   –   Milan Stock Exchange
   –   Swiss Stock Exchange (also Virt-X)
   –   Stockholm/Copenhagen/Helsinki/Oslo (OM)
• Asia:
   –   Tokyo Stock Exchange (TSE)
   –   Taiwan Stock Exchange
   –   Korean Stock Exchange
   –   Australian Stock Exchange (ASX)
   –   Hong Kong Stock Exchange
• Toronto Stock Exchange (TSX)
              US bond markets
• Corporate and government bonds trade OTC in
  wire houses.
  – Inter-dealer brokers often organize markets.
  – E.g., Cantor Fitzgerald (eSpeed)
• NYSE- and AMEX-listed corporate bond markets
  are very small.
           US Derivatives markets
• US Equity options   • US Futures
  –   CBOE              –   CME
  –   Amex              –   CBOT
  –   P-Coast           –   NYMEX
  –   Philly            –   NYBOT
  –   ISE               –   KCBOT
  –   BOX               –   MGE
                        –   …
                     The regulators
• Securities and Exchange Commission (SEC)
   – Securities markets, equity options markets, and cash-settled equity
     index options markets
• Commodity Futures Trading Commission (CFTC)
   – Commodity spot, forward, and futures markets
• The SEC and the CFTC write regulations to interpret and
  implement the laws that fall into their jurisdiction
• They also collect and disseminate information
• Additional regulators include: the Federal Reserve Board
  (Reg. T margins), state-specific SECs, SROs, FASB,
  AIMR, IOSCO, WFE, and ICSA…
A Primer on Orders
                    What are orders?
• Orders are instructions that traders give to the
  brokers and exchanges which arrange their trades.
   –   Instrument (or instruments) to trade.
   –   How much to trade.
   –   Whether to buy or sell.
   –   Conditions
        •   Limit price
        •   Duration
        •   Partial or fill-or-kill
        •   Where to present the order
        •   How to search for other side
        •   Desired counterparts…
                  Who uses orders?
• Traders that either do not have direct access to the
  markets, or do not have the time to monitor the
  markets use orders.
   – Have to anticipate what is going to happen.
   – Have to clearly delineate contingencies.
   – At a disadvantage vis-à-vis professional traders.
      •   Risk of misunderstandings
      •   Conflicts of interest
      •   Speed of reaction to changing market conditions
      •   Cancellations can be time consuming
      •   Access to order flow information
     What are bids and offers (asks)?
• Dealers have an obligation to continuously quote bids and offers, and
  the associated sizes (number of shares), when they are registered
  market markers for the stock.
• Their quotes also have to be firm during regular market hours.
• Public orders with a price limit can also become the market bid or offer
  if they are at a better price than those currently quoted by a registered
  market maker.
• The market’s best bid and offer constitute the inside market, the best
  bid/ask, or the BBO. The best bid and offer across all markets trading
  an instrument is called the NBBO.
• The difference between the best offer and the best bid is the bid/ask
  spread, or the inside spread (touch, fourchette, vigorish…)
• Orders supply liquidity if they give other traders the opportunity to
  trade.
• Orders demand liquidity (immediacy) if they take advantage of the
  liquidity supplied by other traders’ orders.
What are agency/proprietary orders?
• Orders submitted by traders for their own account are
  proprietary orders.
   – Broker-dealers and dealers.
• Since most traders are unable to directly access the
  markets, most order are instead agency orders.
   – Presented by a broker to the market.
• Agency orders can be held or not held/worked.
   – Held orders are those when the broker has an obligation to a client
     to fill the order.
   – Market-not-held orders are institutional orders where the trader
     hires a broker-dealer to execute the order.
   – Working an orders means that a broker-dealer takes some time to
     fill the order.
                     Market orders
• A market order is an instruction to trade at the best price
  currently available in the market.
   – Immediacy
   – Buy at ask/sell at bid => pay the bid/ask spread
   – Price uncertainty
• Suppose the quotes for ABCD are a bid of $50.00 and an
  offer of $50.50, what is the transactions costs for a trader
  using a market buy order in ABCD?
   – Why?
   – What is the best estimate of the value of ABCD?
              Price improvement
• Price improvement is when a trader is willing to step up
  and offer a better price than that of the prevailing quotes
  (at order arrival).
• Who benefits from price improvement?
• Who looses from price improvement?
• Should it be allowed to offer price improvement?
• Should everyone be allowed to offer price improvement?
• Does your answer depend on the minimum price increment
  in the market?
                     Market impact
• Large market orders tend to move prices.
• Liquidity might not be sufficient at the inside quotes for
  large orders to fill at the best price.
   – For example, suppose that a 10K share market buy order arrives in
     IBM and the best offer is $100 for 5K shares.
   – Half the order will fill at $100, but the next 5K will have to fill at
     the next price in the book, say at $100.02 (where we assume that
     there is also 5K offered).
   – The volume-weighted average price for the order will be $100.01,
     which is larger than $100.00.
• Prices might move further following the trade.
   – Information and liquidity reasons.
                           Limit orders
• A limit order is an instruction to trade at the best price available, but
  only if it is no worse than the limit price specified by the trader.
    – OK to trade at or above the limit sell price.
    – OK to trade at or below limit buy price.
• If the limit order is executable (marketable), than the broker (or an
  exchange) will fill the order right away.
• If the order is not executable, the order will be a standing offer to
  trade.
    – Waiting for incoming order to obtain a fill.
    – Cancel the order.
• Standing orders are placed in a file called a limit order book.
        Limit order placement
Limit price placement      Buy orders
Above the best offer       Marketable (aggressive)

At the best offer          Marketable

Between the best bid and   In the market
offer
At the best bid            At the market

Below the best bid         Behind the market
                           Away from the market
Limit orders are trading options
• Limit orders offer other traders an option to trade, that is
  they supply liquidity.
   – Sell limit orders are call options that give traders the right to buy.
   – Buy limit orders are put options that give traders the right to sell.
• What is the option strike price?
• How are limit orders different from regular option
  contracts?
• On what factors does the value of the option to trade
  depend?
   – How do these factors impact the bid ask spread?
Why would anyone use limit orders?
• The compensation that limit order traders hope to receive
  for giving away free trading options is to trade at a better
  price.
• However, options might not fill (execution uncertainty).
   – Chasing the price.
• Limit order traders might also regret having had their order
  filled (adverse selection)…
   – What could cause a limit order to regret obtaining a fill?
   – How would this fact affect strategies involving limit orders?
                   Other order types
• A stop instruction stops an order from executing until price
  reaches a stop price specified by a trader.
   –   Buy only after price rises to the stop price.
   –   Sell only after price falls to the stop price.
   –   Can be either stop market or stop limit orders.
   –   How are stop limit orders different from regular limit orders?
   –   How do stop orders affect liquidity?
• Market-if-touched orders become a market order when
  price reaches some preset touch price.
   –   Buy when market falls to the touch price.
   –   Sell when market rises to the touch price.
   –   How are MIT orders different from regular limit orders?
   –   Do MIT orders demand or supply liquidity?
               Tick-sensitive orders
• Traders who want to condition their orders on the last price
  change submit tick-sensitive orders.
   – Uptick = current price is above the last price
   – Downtick = current price is below the last price
   – Zero-tick = current price is the same as last price
• Do tick-sensitive orders demand or supply liquidity?
• How do tick-sensitive orders compare to limit orders?
• How are tick-sensitive orders affected by the minimum
  price-increment?
         Additional order instructions
•   Day orders (DAY)                   • All-or-none (AON) orders
•   Good-til-cancel (GTC) orders       • Minimum-or-none (MON)
•   Good until orders                    orders
•   Good-this-week (GTW) orders,       • All-or-nothing, and minimum
    good-this-month (GTM) orders         acceptable quantity instructions
•   Immediate-or-cancel (IOC)
    orders                             • Spread orders
•   Fill-or-kill (FOK) orders, good-   • Display instructions
    on-sight orders                        – Hidden/Ice-berg orders/reserve
•   Good-after-orders                  • Substitution orders
•   Market-on-open (MOO) orders
•   Market-on-close (MOC) orders       • Special settlement instructions
                                           – Regular-way settlement
                                           – Cash settlement
                                           – How do these affect the cost of
                                             trading?
Market Structures
                  Market structures
• The trading rules and the trading systems define a market’s
  market structure.
• Call markets versus continuous markets.
   – Call markets allow trades only when the market is called (rotation
     among securities).
   – Continuous markets allow trades anytime during regular trading
     hours.
   – Hybrids of course exist (NYSE, the LSE and soon Nasdaq)
   – Which one would you prefer, and why?
• Trading hours.
   – Most markets limit their regular trading hours.
   – Should markets be open around the clock?
              Quote-driven markets
• Dealers supply the liquidity
   –   Dealers participate in every trade
   –   Dealers may trade with each other (interdealer trading).
   –   Why would dealers need to trade with each other?
   –   How should a customer or broker decide which dealer to approach
       to trade?
• Examples of quote-driven markets
   –   The Nasdaq Stock Market, Inc.
   –   The London Stock Exchange (less liquid stocks)
   –   eSpeed government bond trading system
   –   Reuters 3000 foreign exchange dealing system
              Order-driven markets
• Rule based order handling and trading
   – Order precedence rules
   – Trade pricing rules
   – Auction markets
   – Single price (calls), continuous two-sided auctions, crossing
     networks
   – Can a dealer trade in an auction market?
• Examples of order-driven markets include:
   –   Futures exchanges
   –   Stock and options exchanges
   –   ECNs
   –   Markets for new issues of government debt
                  Brokered markets
• Brokers match up buyer and seller.
   – Search is often required to match buyer and sellers for less liquid
     items, and for large blocks of securities
   – Brokers specialize in locating counterparts to difficult orders
   – Concealed traders
   – Latent traders
• Examples of brokered markets include:
   – Block trading (stocks and bonds)
   – Real estate
   – Business concerns
        Market information systems
• It is of utmost important that orders are not lost and that
  order instructions are understood.
   –   Ticker symbols
   –   Order routing systems
   –   Order presentation systems
   –   Messaging systems
• The information created by trading is valuable.
   – Market data systems report trades to the public
   – Broadcast services
        • Price and sale feeds
        • Ticker tapes
        • Quotation feeds
• Transparency is a key feature of markets.
   – Ex ante vs. ex post transparency
Limit Order books versus Call Markets
             Order Driven Markets
• Trading rules based markets.
   –   Oral auctions
   –   Single price auctions
   –   Continuous electronic auctions
   –   Crossing networks
• The most popular form for new markets.
• Order precedence rules match buyers to sellers.
• Trade pricing rules price the resulting trades.
                           Oral auctions
• Used by many futures, options, and stock exchanges.
    – The largest example is the US government long treasury bond futures
      market (CBOT, 500 floor traders).
• Traders arrange their trades face-to-face on an exchange trading floor.
    –   Cry out bids and offers (offer liquidity)
    –   Listen for bids and offers (take liquidity)
    –   “Take it” = accept offer
    –   “Sold” = accept bid
• Open outcry rule
    – Traders must publicly announce their bids and offers so that all other
      traders may react to them (no whispering…).
    – Traders must also publicly announce that they accept bids/offers.
    – Why is this necessary?
                       Oral auctions
• Order precedence rules
   – Price priority
       • Should a trader be allowed to bid below the best bid, above the best
         ask in an oral auction?
   – Time precedence (futures markets)
       • Is time precedence maintained for subsequent orders at the best bid or
         offer? Why? Why not?
       • How can a trader keep his bid or offer “live”?
       • The minimum tick size is the price a trader has to pay to acquire
         precedence.
   – Public order precedence, time precedence (stock markets)
       • Why do you think this is necessary?
                       Oral auctions
• Trade pricing rule
   – Trades take place at the price that is accepted, i.e., the bid or offer.
   – Discriminatory pricing rule.
       • Why do you think it is called discriminatory? Who gets the surplus?
• Trading floors can be arranged in several rooms as on the
  NYSE, with each stock being traded at a specific “trading
  post.”
• Trading floors can also be arranged in “pits” as in the
  futures markets.
 Rule-based order-matching systems
• Used by most exchanges, some brokerages, and almost all ECNs.
• Trading rules arrange trades from the orders that traders submit to
  them.
• No face-to-face negotiation.
• Most systems accept only limit orders.
    – Why do you think most systems are reluctant to accept market orders?
• Orders are for a specified size.
• Electronic trading systems process the orders.
• Trades may take place in a call, or continuously.
    – A new order arrival “activates” the trading system.
• Systems match orders using order precedence rules, determine which
  matches can trade, and price the resulting trades.
 Rule-based order-matching systems
• Order precedence rules.
   – Price priority
       • Market orders always rank above limit orders…
   – Time precedence
       • Strict time precedence
       • Floor time precedence to first order at price.
            – All subsequent orders at that price have parity
   – Display precedence
       • Why do markets use display precedence?
   – Size precedence
       • Some markets give precedence to small orders, other markets favor
         large orders (NYSE).
       • Why would a market give precedence to large orders?
Example – Pure price-time precedence
 Time    Trader   Buy/Sell   Size   Price
 12:02   Sammy    Sell       100    $20.05
 12:06   Steve    Sell       200    $20.06
 12:15   Bern     Buy        500    $20.06
 12:16   Susie    Sell       300    $20.08
 12:20   Ben      Buy        200    Infinite
 12:21   Bob      Buy        100    $20.08
 12:24   Sandy    Sell       500    $20.12
 12:25   Bev      Buy        500    $20.08
 12:27   Bill     Buy        200    $20.05
 12:27   Seth     Sell       200    $20.10
          Example – the order book
Sellers                      Buyers
Trader     Size   Price      Size     Trader
Sammy      100    $20.05     200      Bill
Steve      200    $20.06     500      Bern
                  $20.08     100      Bob
Susie      300    $20.08     500      Bev
Seth       200    $20.10
Sandy      500    $20.12
                  Infinite   200      Ben
 Clearing the order book with a call at 12:30

Sellers                          Buyers
Trader    Size        Price      Size      Trader
Sammy     100 0       $20.05     200       Bill
Steve     200 100 0   $20.06     500       Bern
                      $20.08     100       Bob
Susie     300 0       $20.08     500 200   Bev
Seth      200         $20.10
Sandy     500         $20.12
                      Infinite   200 0     Ben
        Trades in the example - call
Buyer       Seller    Quantity   Price?

Ben         Sammy     100        Infinity,
                                 $20.05
Ben         Steve     100        Infinity,
                                 $20.06
Bob         Steve     100        $20.08,
                                 $20.06
Bev         Susie     300        $20.08
 Example – the order book after the call
Sellers                   Buyers
Trader    Size   Price    Size     Trader
                 $20.05   200      Bill
                 $20.06   500      Bern
                 $20.08   200      Bev


Seth      200    $20.10
Sandy     500    $20.12
  Example - What should be the price/prices?
• Possibilities include:
    –   Infinite
    –   $20.05
    –   $20.06
    –   $20.08
• The price/prices depends on the trade pricing rules.
• Single price auctions use the uniform pricing rule
    – Everyone gets the same price.
• Continuous two-sided auctions and a few call markets use the
  discriminatory pricing rule.
    – Trades occur at different prices.
• Crossing networks use the derivative pricing rule.
    – The price is determined by another market.
                  Uniform pricing rule
• All trades take place a the same “market clearing price.”
    – The market clearing price is determined by the last feasible trade.
         • Matching by price priority implies that this market clearing price is also
           feasible for all previously matched orders.
    – If the buy and sell orders in the last feasible trade specify different prices,
      the market clearing price can be at either the price of the buy or the price
      of the sell order.
         • The trade pricing rules will dictate which one to use.
• In Example 1, the last feasible trade is between Bev and Susie, so the
  market clearing price is $20.08.
    – Sam, Steve and Susie are happy with a market clearing price of $20.08
      since they were willing to sell at $20.08 or lower.
    – Ben, Bob, and Bev are happy to with a market clearing price of $20.08
      since they were willing to buy at $20.08 or higher.
                  Supply and Demand
• The single-price auction clears at the price where supply equals
  demand.
    – At prices below the market clearing price, there is excess demand.
    – At prices above the market clearing price, there is excess supply.
• Single price auctions maximize the volume of trading by setting the
  price where supply equals demand.
    – Because prices in most securities markets are discrete, there is typically
      excess demand or excess supply at the market clearing price.
    – In the Example, what is the excess demand or supply?
• The single price auction also maximizes the benefits that traders derive
  from participating in the auction.
    – Trader surplus for a seller = the difference between the trade price and the
      seller’s valuation
    – Trader surplus for a buyer = the difference between the buyer’s valuation
      and the trade price.
    – Valuations are unobservable, but we may assume that they at least are
      linked to limit prices.
Example: Demand and Supply
$20.13
$20.12
$20.11
$20.10
$20.09                                       Supply
$20.08                                       Demand
$20.07
$20.06
$20.05
$20.04
         0   300   600   900   1200   1500
         Discriminatory Pricing Rule
• Continuous two-sided auction markets maintain an order book.
    – The buy and sell orders are separately sorted by their precedence.
         • The highest bid and the lowest offer are the best bid and offer respectively.
    – When a new order arrives, the system tries to match this order with orders
      on the other side.
         • If a trade is possible, e.g., the limit buy order is for a price at or above the best
           offer, the order is called a marketable order.
         • If a trade is not possible, the order will be sorted into the book according to its
           precedence.
• Under the discriminatory pricing rule, the limit price of the standing
  order dictates the price for the trade.
• If the incoming order fills against multiple standing orders with
  different prices, trades will take place at multiple prices.
          Continuous trading @12:02
Sellers                       Buyers
Trader      Size   Price      Size     Trader
Sammy       100    $20.05
                   $20.06
                   $20.08
                   $20.08
                   $20.10
                   $20.12
                   Infinite
          Continuous trading @12:06
Sellers                       Buyers
Trader      Size   Price      Size     Trader
Sammy       100    $20.05
Steve       200    $20.06
                   $20.08
                   $20.08
                   $20.10
                   $20.12
                   Infinite
          Continuous trading @12:15
Sellers                        Buyers
Trader      Size    Price      Size      Trader
Sammy       100 0   $20.05
Steve       200 0   $20.06     500 200   Bern
                    $20.08
                    $20.08
                    $20.10
                    $20.12
                    Infinite
   Continuous trading @12:16
Sellers                      Buyers
Trader    Size    Price      Size      Trader
Sammy     100 0   $20.05
Steve     200 0   $20.06     500 200   Bern
Susie     300     $20.08
                  $20.08
                  $20.10
                  $20.12
                  Infinite
          Continuous trading @12:20
Sellers                          Buyers
Trader      Size      Price      Size      Trader
Sammy       100 0     $20.05
Steve       200 0     $20.06     500 200   Bern
Susie       300 100   $20.08
                      $20.08
                      $20.10
                      $20.12
                      Infinite   200 0     Ben
          Continuous trading @12:21
Sellers                            Buyers
Trader      Size        Price      Size      Trader
Sammy       100 0       $20.05
Steve       200 0       $20.06     500 200   Bern
Susie       300 100 0   $20.08     100 0     Bob
                        $20.08
                        $20.10
                        $20.12
                        Infinite   200 0     Ben
          Continuous trading @12:24
Sellers                            Buyers
Trader      Size        Price      Size      Trader
Sammy       100 0       $20.05
Steve       200 0       $20.06     500 200   Bern
Susie       300 100 0   $20.08     100 0     Bob
                        $20.08
                        $20.10
Sandy       500         $20.12
                        Infinite   200 0     Ben
          Continuous trading @12:25
Sellers                          Buyers
Trader      Size      Price      Size      Trader
Sammy       100 0     $20.05
Steve       200 0     $20.06     500 200   Bern
Susie       300 100 0 $20.08     100 0     Bob
                      $20.08     500       Bev
                      $20.10
Sandy       500       $20.12
                      Infinite   200 0     Ben
          Continuous trading @12:27
Sellers                            Buyers
Trader      Size        Price      Size      Trader
Sammy       100 0       $20.05     200       Bill
Steve       200 0       $20.06     500 200   Bern
Susie       300 100 0   $20.08     100 0     Bob
                        $20.08     500       Bev
Seth        200         $20.10
Sandy       500         $20.12
                        Infinite   200 0     Ben
       Summary continuous trading
Buyer      Seller   Size   Price    Bid          Offer
                                                 $20.05x100
                                                 $20.06x100
Bern       Sammy    100    $20.05
Bern       Steve    200    $20.06
                                    $20.06x200
                                    $20.06x200   $20.08x300
Ben        Susie    200    $20.08
                                    $20.06x200   $20.08x100
Bob        Susie    100    $20.08
                                    $20.06x200
                                    $20.06x200   $20.12x500
                                    $20.08x500   $20.12x500
                                    $20.08x500   $20.10x200
     Discriminatory versus uniform
             pricing rules
• Taking the orders as given, large impatient traders prefer
  the discriminatory pricing rule.
• Taking the orders as given, standing limit order traders
  prefer the uniform pricing rule.
• However, orders are not given.
   – Limit order traders tend to price their orders more aggressively in
     the under the uniform pricing rule.
   – Can you explain this prediction?
   – Why would large traders want to split their orders when trading
     under the uniform pricing rule?
   – What role can trading halts have in affecting the pricing rules?
     Continuous versus call markets
• The single price auction produces a larger trader surplus
  than the continuous auction when processing the same
  order flow (example).
   – Concentration of order flow increases total trader surplus.
   – In practice, traders will not send the same order flow to call and
     continuous markets.
• The single price auction will typically trade a lower
  volume than the continuous auction.
   – In our example, both trade 600 shares…
• However, there is another benefit of the continuous market
  – it allows traders to trade when they state their demands.
     The derivative pricing rule and
           crossing networks
• Crossing networks are the only order-driven markets that
  are not auction markets.
   – All trades take place at a price discovered elsewhere.
       • Who owns prices discovered in primary markets?
   – Discover how much buy and sell volume there is at the crossing
     price.
   – ITG’s POSIT, Instinet’s Global Instinet Crossing, and the NYSE’s
     After-hours Trading Session I.
       • Second chance at getting the closing price (4pm)
• Crossing networks are call markets to which traders can
  submit limit orders and market orders.
   – Order precedence rules determine which orders will trade after the
     crossing price has been announced.
        The derivative pricing rule and
              crossing networks
• POSIT runs 8 crosses per day.
    – Choosing a time at random in the 7 minutes following the crossing time.
         • Why do you think they are randomizing the timing?
    – Permits traders to fill their orders at the mid-quote, without price impact.
    – Crosses are completely anonymous and order imbalances are never
      disclosed.
         • Why do you think this is attractive to traders?
• Crossing networks almost invariably have excess demand or supply.
    –   Order precedence rules.
    –   Rationing mechanism.
    –   Less than 10 percent of their order volume ever crosses.
    –   Commissions are reasonable, 1-2c/share.
    Problems with derivative prices
• Stale prices and well-informed traders
   – Crosses take place with some delay relative to the reference price.
   – Between the trade and the establishment of the reference price,
     news might have been released.
       • After-hours trading at Regionals and ECNs…
   – Adverse selection (well-informed traders)
• Price manipulation
   – Temptation to manipulate the price in advance of the cross.
   – Particularly a problem in less liquid stocks.
       • Push prices down (up) if anticipate to buy (sell) in the cross.
   – Illegal, but difficult to detect and prosecute.
Microstructure Data
               Transactions data
• Massive datasets!
• The degree of detail varies considerably across
  datasets
   – London QMG data
   – TAQ – trades no ids and BBO (1993-today)
   – Nastraq – trades no ids and dealer quotes ids (1998-
     2004)
   – TORQ – orders, audit trail, and BBO, some ids (1990)
   – BDM – orders, trades, by type
   – Islad – order, trades, by type
         Calor Group trades Jan. 14, 1991
        Price       Buyer information      Seller information          Flags
         239   0    277 A     831 3426      420 PM     834   3426 A
         243   0    398 I3    844 50000     278 PM     845  50000 A
  MMID 243 0        594 I3    845 50000     278 PM     846  50000 A     MMID
         240   0    278 PM     854 50000    278 A      854 50000 A E
         238   0    910 PM   1052    500    419 A    1053     500 A
         240   0    910 PM   1102 20000     921 A    1102 20000 A
Capacity 241 8790   278 I3   1103 10000    910 PM    1103 10000 A      Capacity
         238   0    910 PM    1133 850      545 A     1133   850 A
         238   0    910 PM    1154 636      189 A     1154   636 A
         243   0    398 A    1231 15000    398 MX    1231 15000 A E
  Time                                                                   Time
         238   0    398 PM    1247 1000     248 A     1247  1000 A
         238   0    420 PM    1319 101      346 A     1319    101 A
         238   0    420 PM    1437 466      346 A     1437    466 A
   Size  238   0    420 PM    1533 275      346 A     1533    275 A      Size
         239   0    278 PM    1554 6500     278 A     1554  6500 A E
         238   0    910 PM    1614 500      865 A     1614    500 A
         238   0    591 P     1615 1700     248 A     1629  1700 A
        Calor Group quotes Jan. 14, 1991
                     Bid Bsize Ask Asksize              Flags
        81546 163241 230 0 25000 220 0 25000 O    910
Start   82530 105531 232 0 25000 222 0 25000 O    362           Market Maker ID
        82629 85646 232 0 10000 222 0 10000 O F    36
        82852 105521 232 0 10000 222 0 10000 O    594
        82907 83813 230 0 25000 220 0 25000 O     278
End     82947 103334 232 0 25000 222 0 25000 O      6
        83814 105530 230 0 25000 220 0 25000      278
        85647 105544 231 0 10000 221 0 10000 F     36
        90259 91036 232 0 25000 222 0 25000 O     398
        91532 105523 232 0 25000 222 0 25000 O    398
        103335 105503 230 0 25000 220 0 25000       6
        105504 111950 228 0 25000 218 0 25000       6
        105522 164418 230 0 10000 220 0 10000     594
        105524 164327 230 0 25000 220 0 25000     398
        105531 164418 228 0 25000 218 0 25000     278
        105532 164019 230 0 25000 220 0 25000     362
        105545 105738 230 0 10000 220 0 10000 F    36
        105739 163051 229 0 10000 219 0 10000 F    36
        111951 164030 225 0 25000 215 0 25000       6
                   TAQ data
• Period covered is 1993-today
• Available either on CDs or via WRDS
• All trades in NYSE-, Nasdaq-, Amex-listed
  stocks.
• Trade information (Time, Price, Size, Flags)
• BBO (inside quotes from each market)
• We will use this data for Project II IBM (7/2002)
                   Nastraq data
•   Period covered is 1998-today.
•   Available either on CDs or via WRDS
•   All trades in Nasdaq-listed stocks.
•   Trade information (Time, Price, Size, Flags)
•   BBO (inside quotes from each market)
•   Dealer quotes (quotes from each market maker)
•   We will use this data for Project II MSFT (7/2002)
                        TORQ data
•   144 NYSE stocks from size deciles
•   Nov 1, 1990 – Jan 31, 1991
•   Transactions
•   BBO
•   Order data
    –   Submissions
    –   Revisions
    –   Cancellations
    –   Executions
• Audit trail
                             BDM data
• We will use this as an example of data from an electronic
  limit order market.
• Trades
• Orders
   –   Order submissions
   –   Order revisions
   –   Order cancellations
   –   Order executions
• Build limit order book
• Create inside quotes
Ticker   Date   Time   Seq   Price   Volume   Put-through
               Order ref      Begin date       End date    Chaining code Entry date      Entry time


         Order size Discl. Size     Price            J=EDO, D, R=GTC, L=GTC, E=FOK
A=Buy




                                  0=limit, 1=at market, 2=opening, 3=best, 9=not sign.




V=Sell                                                J=EDO, D, R=GTC, L=GTC, E=FOK
      Agency auction/ floor: NYSE
• One designated MM/stock, 9 specialist firms.
   – Specialist participation rate is less than 20%.
• SuperDot
   – Handles 85% of orders, of value
• OARS
• Floor brokers manually trade orders
   – Represent roughly 50% of value traded
• Crowd = floor brokers and specialist
• Direct+, OpenBook
   – New features
• Upstairs facilitated trades
  Specialists’ affirmative obligations
• Specialists are traders of last resort.
    – Have to quote firm two-sided markets during trading hours.
• Specialists have an obligation to smooth prices by intervening to
  prevent large price reversals (provide price continuity).
    – Expensive if informed traders in the market.
    – Profitable if liquidity is low because other traders are distracted.
• Exchanges regularly evaluate specialists based on the width of their
  quotes, the depth at their quotes, and price continuity.
• Specialists provides
    –   Liquidity when there are order imbalances
    –   Price continuity
    –   Limit order display
    –   Supposedly stabilize prices
              Specialists also do…
• Specialists represent system order flow.
   – Orders that are routed electronically to the exchange for execution.
   – Specialists get compensated for this service in the form of
     commissions (for orders that stay on the book (NYSE>5 min)).
• Specialists also work orders entrusted to them by floor
  brokers (CAP, go-along orders).
• Specialists act as bulletin boards.
• Specialists have a responsibility to make sure that all
  traders follow the exchange rules.
   – Conduct an orderly market.
                  Specialist privileges
• Specialists can engage in:
     – Speculative trading on their own account.
     – Quote-matching
     – Cream-skimming
         • Observe broker IDs for incoming orders…
     – Strategies to take advantage of stop orders
• Specialists control the quotes
     – Limit display to top-of-file
     – Constrained by order exposure rules
•   Specialists can stop incoming marketable orders.
•   Specialists conduct the open.
•   Specialists receive brokerage commissions for system orders.
•   Specialists have a unique information advantage that they can use to
    generate dealer profits.
    Specialists’ negative obligations
• Abide by order preference rules, including public order
  preference.
• Public liquidity preservation principle is typically enforced
  at primary exchanges.
   – Specialists can trade only with incoming marketable orders.
• Third market dealers and regional specialists are generally
  not subject to the public liquidity preservation principle.
   – Dealers’ benefit of trading against stale limit orders is somewhat
     offset by limit order price protection guarantees.
         Dealer market Nasdaq/Seaq
•   Two or more market makers per stock.
•   Trades were mainly phone negotiated.
•   Roughly 95% of the volume went through MM book.
•   No central limit order book.
•   Small order execution automated, but not larger orders.
•   Complete decentralization
•   ATS/ECNs
•   Upstairs trading
         Market maker obligations
•   Provide quotes during trading hours
•   Offer “best execution”
•   Report trades in a timely manner
•   Fair communication
•   No churning
     Electronic Trading Platforms
• Centralized order-driven market with automated
  order routing.
• Decentralized computer network for access.
• Member firms act as brokers or principals.
• No designated market makers
• Central limit order book/information
  system/clearing and settlement
• Off-book trading is sometimes significant

								
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