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									    BIZ8016-01
Market Microstructure


     Kee H. Chung
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.
   “Market microstructure is the study of
    the process and outcomes of exchanging
    assets under explicit trading rules.”
    (Maureen O’Hara, a former president of the
    American Finance Association)

   Market microstructure has a profound
    impact on the real world – on traders,
    broker/dealers, exchanges, regulators, and
    policy makers alike.
Why do we care?
 Data guided by theory, theory guided by
  data

 Market design issues
  Agency auction market
  Dealer market
  Electronic limit order books
Market performance issues
 • Transaction costs
 • Shock absorption/resiliency
 • Trading halts


Efficiency – welfare issues
 • Is insider trading bad?
Topics to be covered
Part I: Foundation and Protocols

   Orders and order properties
   Market structure
   Order-driven markets
   Dealer markets
Part II: Analytics and Models

   Informed trading and market efficiency
   Bid-ask spreads
   Measurement of trading (execution) cost
   Adverse selection models
   Spread component models
    Part III: Select Topics

 Trade classification
 Nasdaq controversy, stock price clustering,
  and SEC market reforms
 Order preferencing
 Market structure and execution costs
 Minimum price variation (tick size) and
  decimalization
    Part III: Select Topics (Continued)

 Competition in dealer market
 Intraday patterns and test of alternative
  theories
 Spread and depth: Joint decision variables
 Trades, information, and prices
 Commonality in liquidity
 Market microstructure and interactions with
  other areas
   Chapter 4
Orders and Order
   Properties
Orders
   Orders are instructions to trade that
    traders give to brokers and exchanges that
    arrange their trades.

   Orders always specify
    •   The security to be traded
    •   The quantity to be traded
    •   The side of the order (buy or sell)
   Orders may specify
    • Price specifications
    • How long the order is valid
    • When the order can be executed
    • Whether they can be partially filled or not
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. Use
       standard orders to avoid mistakes.
 Traders who use orders are 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
 Some important terms 1

 Bid: buy order specifying a price (price is
  called the bid).
 Offer: sell order specifying a price (price
  is called offer or ask).
 Best Bid: standing buy order that bids the
  highest price bid.
 Best offer: standing sell order that has
  the lowest price offer.
Some important terms 2

   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.
Some important terms 3
   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.
Some important terms 4
   The difference between the best offer and
    the best bid is the bid/ask spread, or the
    inside spread (touch).

   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.
Market orders
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

   Fills quickly but sometimes at inferior
    prices.
   Used by impatient traders and traders who
    want to be sure that they will trade. It is
    usually thought that insiders use that type
    of order.

   When submitting a market order execution
    is nearly certain but the execution price is
    uncertain.

   Takes liquidity from the market in terms of
    immediacy. They then pay a price for
    immediacy, which is the bid-ask spread.
    Market order: Example 1
Suppose that the quote is 20 bid, 24 offered.
 Suppose that the best estimate of the true
 value of the security is 22.

   A market buy order would be executed at 24
    for a security worth 22.

   The price paid would be 24 and therefore the
    price of immediacy would then be 2.
Market order: Example 2

   A market sell order would be executed at
    20 for a security worth 22.

   The price received would be 20 and
    therefore the price of immediacy would
    then be 2.

   The price of immediacy is the bid-ask
    spread.
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 loses from price improvement?
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.

   Prices might move further following the
    trade.
     • Information and liquidity reasons.
Market impact: Example
  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.
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.

    •   For a limit buy order, the limit price
        specifies a maximum price.

    •   For a limit sell order, the limit price
        specifies a minimum price.
Limit orders: Examples
 If you submit a limit buy order for 100
  shares (round lot) of Dell with limit price of
  $20. This means that you do not want to
  buy those 100 shares of Dell at a price
  above $20.
 If you submit a limit sell order for 100
  shares (round lot) of Dell with limit price of
  $24. This means that you do not want to
  sell those 100 shares of Dell at a price
  below $24.
 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 price placement: (from very
aggressive to least aggressive)
    Marketable limit order: order that can
     immediately execute upon submission (limit
     price of a buy order is at or above the best offer),

    At the market limit order: limit buy order with
     limit price equal to the best bid and limit sell
     order with limit price equal to the best offer,

    Behind the market limit order: limit buy order
     with limit price below the best bid and limit sell
     order with limit price above the best offer.
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
A standing limit order is a trading
option that offers liquidity
  A limit sell order is a call option and a limit
   buy order is a put option. Their strike
   prices are the limit prices.
  A limit order is not an option contract (not
   sold).
  The option is good until cancelled or until
   the order expires.
  The value of the implicit limit order option
   increases with maturity.
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?
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
Market Microstructure Seminar - T&E Chapter 4
    Stop orders
 Activates when the price of the stock
  reaches or passes through a predetermined
  limit (stop price). When the trade takes
  place the order becomes a market order
  (conditional market order).
 Buy only after price rises to the stop price.
 Sell only after price falls to the stop price.
   Stop orders are typically used to close down
    losing positions (stop loss orders).

   Mainly used on market orders and few on
    limit orders.
Example: Suppose that the market for Dell is
  currently 20 bid, 24 offered.

   Suppose that you place a stop loss order for
    1,000 shares of Dell at a stop price of 15.

   Suppose that after having placed that order, the
    market falls to: 13 bid, 15 offered. The bid price
    passed your stop price.

   Your order is then executed at 13 provided there
    is enough quantity at that price.

   The stop price may not be the price at which you
    are executed, as above.
Difference between stop orders and
limit orders

   The difference lies in their relation with
    respect to the order flow.

   A stop loss order transacts when the market
    is falling and it is a sell order. Therefore
    such an order takes liquidity away from the
    market (it must be accommodated so it
    provides impetus to any downward
    movement).
   A limit order trades on the opposite side of
    the market movement. If the market is rising,
    the upward movement triggers limit sell
    orders.

   Outstanding limit orders provide liquidity to
    the market.
Order validity and expiration
instructions
   Day orders (DAY)            Fill-or-kill (FOK)
   Good-till-cancel (GTC)       orders, good-on-sight
    orders                       orders
   Good until orders           Good-after-orders
   Good-this-week (GTW)        Market-on-open
    orders, good-this-           (MOO) orders
    month (GTM) orders
   Immediate-or-cancel         Market-on-close
    (IOC) orders                 (MOC) orders
Quantity instructions
   All-or-none (AON) orders

   Minimum-or-none (MON) orders

   All-or-nothing, and minimum
    acceptable quantity instructions
   Chapter 5
Market Structures
Trading sessions

   Trades take place during trading sessions.

    •   Continuous market sessions
    •   Call market sessions
Continuous markets
   Traders may trade at anytime while the
    market is open.

   Traders may continuously attempt to
    arranger their trades.

   Dealer markets or quote driven markets are,
    by definition, continuous markets.
Pros and cons of continuous
markets
   Pros for continuous markets
    • Traders can arrange their trades whenever they
      want.
    • Information may be incorporated very fast into
      prices.


   Cons for continuous markets
    •   more volatile
Call markets
   Traders may trade in call markets only
    when the market is called.

   You may have all securities called at the
    same time or only some. The market may
    be called several times per day.

   Used to open sessions in continuous
    markets (Bourse de Paris, NYSE,…). Also
    used for less active securities, bonds,….
Pros and cons of call markets
Pros for call markets

  • Focus the attention of traders on the same
    security at the same time.
  • Less volatility

Cons for call markets

  • Information may need a lot of time to be
    incorporated into prices.
Execution systems
 Theexecution system matches the
 buyers with the sellers.
    quote-driven markets
    order-driven markets
    brokered markets
    hybrid markets
Quote-driven dealer markets
   In pure quote-driven markets, dealers
    participate in every trade.

   Dealers provide all the liquidity and quote
    bid and ask prices. Those quotes are firm
    for some specified size, i.e., the dealers
    must honor them.

   If the investor wants to trade a different size,
    there will be negotiation between the
    investor and the dealer.
   Buy orders decrease the dealer’s
    inventory position whereas sell orders
    increase the dealer’s inventory position.

   The dealer can then attract or reject order
    flow given her inventory position. The bid-
    ask spread’s placement will then reflect
    her inventory position.
   When the dealer’s inventory position is
    low, she sets both a high bid price and a
    high ask price.

   When the dealer’s inventory position is
    high, she sets both a low bid and a low
    ask.
Examples of Dealer Markets:

•   NASDAQ
•   London International Stock Exchange
    (SEAQ)
•   OTC Bond Markets
•   Foreign Exchange Markets
General features of a dealer market
   Multiple dealers, geographically dispersed,
    electronically linked.
   No consolidation of trading: No “floor”.
   Virtually all customer trades are with a dealer.
   The dealer is the intermediary.
   Customers rarely trade against other customers.
   Dealers trade among themselves.
   Regulation and transparency are poor relative to
    floor markets.
   Dealers may compete among themselves, but have
    a lot of information and market power relative to
    customers.
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
Dealer obligations
 Provide quotes during trading hours
 Offer “best execution”
 Report trades in a timely manner
 Fair communication
Order-driven markets (Ch. 6)
 In an order-driven auction market, all traders
  issue orders to the exchange.
 Buyers and sellers regularly trade with each
  other without the intermediation of dealers.
 But dealers may choose to trade.
 Order driven markets may be organized as
  continuous markets or as call markets.
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
Hybrid markets
Hybrid markets mix aspects of the various
 structures.

 The most common hybrid markets are
  those with dealer-specialists.
 These markets are order-driven auction
  markets in which the specialist must provide
  liquidity under some circumstances.
 Most US stock exchanges and options
  exchanges have specialist systems.
    Chapter 6
Order-driven Markets
Order-driven markets
 Most important exchanges are order-
  driven markets.
 Most newly organized trading systems are
  electronic order-driven markets.
 All order-driven markets use order
  precedence rule and trade pricing rule.
Examples of pure order-driven
markets
- Tokyo Stock Exchange,
- KSE, KOSDAQ
- Paris Bourse,
- Toronto Stock Exchange,
- Most Future Markets,
- Most European Exchanges for equities
  (Milan, Barcelona, Madrid, Bilbao,
  Zurich,….)
Types of order-driven markets
   Oral auctions

   Rule-based order matching systems
    • Single price auctions
    • Continuous order book auctions
    • Crossing networks
In order-driven markets, trading rules specify
  how trades are arranged:

- order precedence rules: match buy orders
  with sell orders
1. Price priority
2. Time precedence or time priority

- trade price rules: determine the trade price
1. Uniform pricing rule (single price auction)
2. Discriminatory pricing rule
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 – the first rule of oral
 auctions

 •   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?
 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
        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
          Why do you think this is necessary?
 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

 •   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 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.
Order precedence rules
Price   priority
  • Market orders always rank above limit
    orders.
  • Limit buy orders with high prices have
    priority over limit buy orders with low
    prices
  • Limit sell orders with low prices have
    priority over limit sell orders with high
    prices.
Time precedence
 • Under time precedence, the first order at
   a given price has precedence over all
   other orders at that price. Gives orders
   precedence according to their time of
   submission.
 • The pure price-time rule uses only price
   priority and time precedence.
 • Floor time precedence to first order at
   price. All subsequent orders at that price
   have parity (Oral auction)
 Display   precedence
 •   Why do markets use display precedence?
 Size   precedence
 •   Some markets give precedence to small
     orders, other markets favor large orders
     (NYSE).
 Public   order precedence
 •   Public orders have precedence over
     member orders at a given price.
   Trades are arranged by matching the
    highest ranking buy orders with the highest
    ranking sell orders.

   Order precedence rules are used to rank
    orders.

   Order precedence rules vary across
    markets. However, the first rule is almost
    always price priority.
Trade pricing rules

Single price auctions use the uniform
 pricing rule. Most continuous order-
 driven markets use the discriminatory
 pricing rule.
Uniform pricing rule

   All matched orders are executed at the
    same price.

   This rule is used for opening markets in
    many equities markets, following trading
    halts for many continuous markets, and in
    the AZX,….
Discriminatory pricing rule
   In a continuous market trade takes place
    when an incoming order is matched with a
    standing limit order.

    Under the discriminatory pricing rule, the
    trade price is the limit price of the standing
    limit order.
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.
What should be the price/prices?
   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 at 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.
   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.
 Ifthe 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.
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.
Discriminatory Pricing Rule
   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 vs. uniform pricing rules
   Taking the orders as given, large impatient
    traders (e.g., liquidity demanders:
    marketable limit orders) prefer the
    discriminatory pricing rule (to exploit better
    price).

   Taking the orders as given, standing limit
    order traders (liquidity suppliers) prefer the
    uniform pricing rule (to maximize surplus).
   However, orders are not given.
    • Limit order traders tend to price their orders
      more aggressively 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…
    •   See textbook example (Table 6-7 & 6-8)

   However, there is another benefit of the
    continuous market – it allows traders to trade
    when they state their demands.
Additional examples
Example 2: Batch market and surplus
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
The (limit order) book
 The broker might have other limit orders
  besides ours. A collection of unexecuted
  limit orders is a “book”.
 The book may have buy and sell orders.
 In US futures pits, each broker may have
  his/her own book.
 In many other markets, the book is
  consolidated: all unexecuted limit orders
  are recorded in one book.
The electronic limit order book
 All orders are limit orders.
 The book is electronically visible.
 “Anyone” may enter an order.
 There has to be some established
  relationship for clearing and credit purposes.
 The electronic limit order book is probably
  the most common form of new market
  organization today, but it is far from
  universal.
The Island ECN (now INET)

 Island is a limit order market
 Island is an Electronic Communications
  Network (ECN)
 It has no trading floor. All orders are sent
  electronically.
A likely scenario:
Seller(s), using market orders, took out the
113.25 bid and the 113.00 bid, leaving 112.5 as
  the best bid.

On the sell side of the book, sellers realized that
113.375 was unrealistically high. They’re now
offering at a lower price (112.95)
A survey of usage
   Some markets have a single consolidated
    limit order book, where everything happens.

    This is mostly true of the Tokyo Stock Exchange,
    Euronext, the Singapore Stock Exchange, the
    Taiwan Stock Exchange, etc., etc.

   Other markets are fragmented.

    There are multiple limit order books in different
    physical venues (or computers).
   In addition to the Island ECN, there is a
    limit order book for IBM at the New York
    Stock Exchange, the Boston Stock
    Exchange, the Pacific Stock Exchange,
    etc., etc.

   The largest (deepest) limit order book for
    IBM is at the NYSE.
Different markets/different solutions
 The pit markets in US futures exchanges do
  not have a centralized limit order book.
 The Chicago Board Options Exchange does
  have a centralized book (run by a clerk).
 The NYSE has a limit order book, run by
  the specialist. (But there are other books in
  NYSE-listed stocks on regional exchanges
  and other dealers.)
 NASDAQ has multiple books.
   ECN의 개념 대체거래시스템(Alternative Trading System:
    ATS)의 일종으로 ECN(Electronic Communications
    Network)은 컴퓨터 네트워크를 활용하여 인터넷을
    기반으로 주식을 매매, 거래소시장의 기능을 수행하는
    대체증권시장 또는 사이버(온라인) 증권시장입니다.
    한국증권시장에서의 ECN이란 “정규의 증권시장 이외의
    장소에서 유가증권(주식)의 매매를 중개하는
    전자장외증권거래시스템”을 의미합니다.
    장외시장의 한 형태로서 자율규제의 기능을 갖는
    거래소가 아니므로 증권거래소 또는 증권시장이라는
    명칭의 사용이 거래법에 의해 금지된 ECN은
    대체거래시스템인 ATS(Alternative Trading System)와
    구분되는 개념이기는 하나 국제적으로는 증권시장의
    기능을 수행하는 대체증권시장을 ECN 또는 ATS로
    혼용하여 사용하고 있습니다.
ECN의 등장배경 - 해외

   ECN은 1969년 미국의 Institutional Network사가 전자거래시스템인
    Instinet을 설립한 것으로부터 유래하고 있습니다. 초기 Instinet의
    설립목적은 기관투자자들이 전자단말기를 통하여 거래소외에서
    상호간 주식을 직접거래하기 위한 것이었습니다. Instinet 출범 이후
    ECN이 급격하게 성장하게된 계기는 인터넷을 통한 주식거래의
    급증과 주문처리규정(Order Handling Rule:OHR)의 제정과 같은
    제도적 뒷받침이라고 할 수 있습니다.

   기존의 Nasdaq이 호가주도형 딜러시장으로서 마켓메이커에 의한
    시장분할 구조문제를 가지고 있었기에, ECN은 이러한 제도적 장치를
    통해 Nasdaq 거래량의 약 35.3%(2002년 2월말 기준)를 차지하는
    시장으로 성장하였습니다.
ECN의 등장배경 - 국내
   1997년 IMF관리체제 이후 경제위기의 방지대책으로서 정부는
    경제구조에 대한 전반적인 검토를 하게 되었고, 이에 따른 금융산업
    전반의 제도적 개선과 규제완화등이 이루어졌습니다. 그 중에서도
    증권시장에 대해서는 2001년 3월 28일 증권거래법 개정을 통하여
    시장진입장벽을 완화하고 새로운 형태의 증권거래시스템의 발전을
    도모하며 국제간 증권거래의 활성화를 위한 방안으로 ECN제도를
    도입하게 되었습니다 (증권거래법 제2조제8항제8호).

   ECN제도의 도입이후, 한국 최초의 ECN을 설립하기 위해 국내
    유수의 증권사들이 출자한 한국ECN컨설팅㈜가 2001년 6월 1일
    설립되었고, 2001년 12월 14일 증권회사로서 금융감독위원회의
    허가를 얻어 한국ECN증권㈜로 개명하여, 12월 27일에 역사적인
    전자장외증권거래 업무를 시작하게 되었습니다.

   Closed on May 28, 2005
임의체결(Random end)방식이란?
   임의체결방식이란 일정한 구간(window, 5분)내에서
    고정된 체결시각이 아닌 난수발생에 의해서 임의로
    결정된 체결시각에 체결이 한번 발생하는 방식.
   임의체결(Random end)방식은 단일가매매시에 발생할 수
    있는 허수호가를 효과적으로 방지하기 위하여, 미국, 영국
    그리고 독일등의 선진증권시장에서 사용중인 제도.
   정확한 체결시점을 투자자가 알지 못함으로써
    허수호가의 입력 및 시세조작의 개연성을 미연에 방지할
    수 있으며, 5분간의 체결구간 내에서 난수발생을 통해
    체결시각을 결정.
체결구간
   1차 체결오후 4시55분~5시00분
   2차 체결오후 5시25분~5시30분
   3차 체결오후 5시55분~6시00분
   4차 체결오후 6시25분~6시30분
   5차 체결오후 6시55분~7시00분
   6차 체결오후 7시25분~7시30분
   7차 체결오후 7시55분~8시00분
   8차 체결오후 8시25분~8시30분
   9차 체결(장종료)오후 8시55분~9시00분
 거래시간은 오후 4시30분부터 장종료시점.
 장종료시점은 임의체결방식의 특성상
  일정한 시각에 고정되어 있지 않기 때문에
  5분간의 체결구간(오후
  8시55분~9시00분)내에서 유동적.
 호가접수는 오후 4시30분부터 시작하며,
  첫번째 체결은 오후 4시55분~5시00분
  사이에 이루어 집니다.
체결우선원칙
   시장원칙에 입각하여 가격우선원칙과
    시간우선원칙만을 적용.
   매도·수 주문간에는 유리한 가격의 주문이
    선행하며, 동일한 가격간에는 시간우선원칙이
    적용되며 상·하한가인 경우에도 적용.
   지정가주문이란 투자자가 종목이나 수량 및
    가격을 지정하여 주문을 내는 것으로 지정한 가격
    또는 그 가격보다 유리한 가격으로 체결가격이
    결정될 때에만 해당주문이 체결이 되는 주문.
    지정가주문과 그에 상응하는 정정, 취소주문만이
    가능.
ECN 거래대상종목
   현재 거래소의 KOSPI 200 구성종목과 코스닥의
    KOSDAQ 50 구성종목-총 250종목-을
    거래대상종목으로 하고 있으며, 이들
    거래대상종목들 중에서 거래소 및 코스닥에서
    거래정지가 된 종목은 제외됩니다.
    한국ECN증권㈜의 거래시간 중 투자자보호를
    위해서 필요할 경우에는 ECN업무규정
    제50조에 의거하여 장중 매매거래정지를 취할 수
    있습니다.
Close of ECN – May 28, 2005
   지난 2001년 개설 추진 당시는 개인
    직접투자가 활발한 한국시장의 특성상
    활성화되리라는 기대가 컸지만 만성적
    거래부진에 시달리며 누적적자가 130억원.
시간외거래

지난 2001년 말 개설된
장외전자거래시장(ECN)이 지난 28일로 문을
닫고 이 업무를 증권선물거래소가 넘겨받아
30일부터 시간외 거래를 오후 6시까지
연장하는 형태로 운영.

기존 ECN시장과 마찬가지로 30분 단위로
체결되는 단일가 매매제도가 적용.
   기존 ECN시장이 원칙적으로 10주 단위
    거래인 반면 시간외 거래는 1주씩인 점,
    기존 ECN에서는 KOSPI200과 KOSDAQ50
    편입종목으로 거래가 제한됐지만 시간외
    거래에서는 전 종목 거래가 가능.

   시간은 차이…구조는 비슷=기존 ECN이
    오후 4시30분∼9시에 매매가 이뤄졌다면 새
    시간외 매매제도는 오후 3시30분∼6시에
    매매가 이뤄진다.
   정규시장 종가에서 원칙적으로 ±5%
    범위내에서 가격변동을 허용한다는 점과
    허수성 호가방지를 위해 '랜덤 엔드'제도를
    적용하고 있는 점도 같다.
 기존 장외전자거래시장(ECN)의 기능을
  흡수하기 위해 도입된 ‘시간외
  단일가매매거래’가 기존 거래액의 4배에
  이르는 등 급증.
 증권선물거래소가 지난 5월30일 도입한
  시간외 단일가매매의 1개월간 실적을
  분석한 결과, 시간외 매매의 거래대금은
  기존 하루 평균 14억원(ECN)에서
  58억원으로 무려 315%가 늘었다.
   거래종목도 종전(하루 평균 기준) 99개에서
    413개로 317%가 늘었고, 거래량도
    24만주에서 152만주로 529%가 증가.
    투자자(계좌 기준)도 하루 1930명에서
    5914명으로 늘었으며, 이 가운데 외국인
    투자자 비중이 10.8%에 이르는 등 범위도
    확대.
   매매가격은 유가증권시장에선 48.9%,
    코스닥시장에선 43.1%가 종가로 결정돼,
    가격형성도 비교적 안정적인 것으로
    나타났다.

   이는 시간외매매시장이 정규시장 종료후
    투자자의 거래수요를 수용하고, 거래소의
    시장운영에 대한 투자자의 신뢰 증대에서
    비롯됐다는 게 거래소측의 설명.
Limit order books: The problem
areas
 Electronic limit order books are the
  predominant continuous trading
  mechanism.
 They do not seem to work well, however,
  in all circumstances. These include large
  trades, low activity securities and market
  breaks (“crashes”)
 In these circumstances, some sort of
  active marketmaking presence (a dealer)
  seems to be necessary.
     Chapter 10
Informed Traders and
   Market Efficiency
Informed traders
 Acquire and act on information about
  fundamental values.
 Buy (sell) when prices are below their
  estimates of fundamental value.
 Include value traders, news traders,
  information-oriented technical traders, and
  arbitragers.
Fundamental values
 The true values
 Not perfect foresight values
 Prices are said to informative when they
  are equal to fundamental values
 Fundamental values are not predictable
  (why?)
 Price changes in efficient markets are not
  predictable (why?)
Informed traders make prices
informative
   Because they buy (sell) when price is below
    (above) their estimates of fundamental value,
    their trading move prices toward their estimates
    of fundamental value.
   When informed traders accurately estimate
    values, their trading makes prices more
    informative.
The market price is more informative
(accurate) than individual value estimates
V = the true fundamental value,
P = the market price,
vi = value estimate of trader i; vi = V + ei, where E(ei) = 0,

Di = trader i’s desired position in the security;
         Di = a(vi – P), where a is a constant.

From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have
∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0
→ ∑vi = ∑P = N * P → P = (1/N) ∑vi

P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.
Informed trading strategies
 Must minimize price impact to maximize
  profits.
 Trade aggressively when their private
  information will soon become common
  knowledge.
 Trade slowly when their private information
  will not soon become common knowledge.
 Trade aggressively when other traders will
  act on the same information.
Liquidity and Predictability-Strategic
Trading with Private Information and Price Impact

 If you buy a contract, you receive $1 with a
  probability of π and zero with 1- π.
 The market price of the contract is
 P = 0.3 + ¼(Q/L), where Q is your trade size and
  L denotes liquidity.

Your profit = πQ – PQ = πQ – [0.3 + ¼(Q/L)]Q
Your profit is maximized when Q = 2L(π – 0.3)
Your maximum profit = L(π – 0.3)2
Styles of informed trading
 Value traders – all information
 News traders – new information
 Information-oriented technical traders –
  predictable price patterns
 Arbitragers – relative instrument values
  rather than absolute instrument values
Informed trading profits
 Precise and orthogonal estimates
 Impossibility of informationally efficient
  markets (Grossman and Stiglitz)
 Three forms of efficient markets
  hypothesis
  Chapter 13 &14
Dealers and Bid-Ask
      Spreads
What defines a dealer?
A broker acts as an agent for a customer,
representing customer orders in the market
(e.g., a real estate broker).
A dealer takes the other side of customer
trades (e.g., a used-car dealer).
Much of US securities regulation applies to
both brokers and dealers. The US Securities
and Exchange Commission (SEC) refers to
such people as “broker-dealers”. In fact,
broker and dealer functions are quite distinct.
Dealer quotes
 Dealer spread vs. inside spread
 One-sided vs. two-sided market
 Firm vs. soft quotes
 Quoted vs. realized spread
 Best execution rule
 Order preferencing
The bid-ask spread
 The bid-ask spread is the difference
  between the ask price and the bid price
  (quoted spread).
 The quoted spread gives an estimation of
  the remuneration of the service provided by
  dealers to traders. The remuneration
  increases with the spread.
 Dealers make money by buying low and
  selling high. They lose money when
  market conditions lead them to buy at high
  prices and sell at low prices.
The realized spread

The realized spread (difference between
 the price at which dealers effectively buy
 and sell their securities) is the true
 remuneration of providing liquidity.
Dealer inventories
   Inventories are positions that dealers have
    on the security they trade. They may hold a
    long position or a short position.

   Target Inventories are positions that
    dealers want to hold.

   Dealers’ inventories are in balance when
    they are near the dealers’ target levels and
    out of balance otherwise.
Inventory risk
 For risk averse dealers any difference
  between inventories is costly.
 They then require compensation for
  absorbing transitory mismatches in supply
  and demand over time (transitory risk
  premium).
 The larger the mismatch, the greater the risk
  the dealer must assume and the greater the
  compensation required by dealers.
Dealer inventory control
 Dealers may act to control their inventories.
 As dealers’ prices affect other traders’
  trading decisions, the placement of the
  dealers’ bid-ask spread may be used to
  control their inventories.
 When dealers’ inventories are below (above)
  their target inventories, they must buy (sell)
  the security.
   Dealers increase their prices (bid and ask)
    when they want to increase their inventory.
    •   Higher bid prices encourage traders from selling
        to them and higher ask prices discourage
        traders from buying from them.
   Dealers decrease their prices when they
    want to decrease their inventory.
    •   Lower bid prices discourage traders from selling
        to dealers and lower ask prices encourage
        traders from buying from the dealers.
Depth (size) control
Inventory risk
   Diversifiable inventory risk
    • When future price changes are independent of
      inventory imbalances
    • Can be minimized by dealing in many
      instruments
   Adverse selection risk
    • When future price changes are inversely related
      to inventory imbalances
    • Arises when dealers trade with informed traders
Adverse selection losses
Informed traders buy when they think that
 prices will rise and sell otherwise.
When dealers trade with informed traders,
  • prices tend to fall after the dealers buy and
    rise after the dealers sell (i.e., future price
    changes are inversely related to inventory
    imbalances)
  • their realized spreads are often negative.
Dealer optimization problem
   Dealers always gain to liquidity-motivated
    transactors.

   Dealers can balance the losses made on
    informed trading with the profits made on
    uninformed trading.
Dealer optimal responses when
sold to an informed trader
 Raise ask price and lower ask size
 Raise bid price and increase bid size
 Buy from another trader at his ask price
 Buy a correlated instrument
Dealer optimal responses when
bought from an informed trader
 Lower ask price and raise ask size
 Lower bid price and reduce bid size
 Sell to another trader at his bid price
 Sell a correlated instrument
Dealer optimal responses when the
next trader is an informed traders
 Ask price = the best estimate of
  fundamental value, conditional on the next
  trader being a buyer. (regret-free price)
 Bid price = the best estimate of
  fundamental value, conditional on the next
  trader being a seller.
 Because dealers generally do not know
  whether the next trader is well informed,
  they use the probability that the next trader
  is well informed.
Bid/ask spreads – Chapter 14
 The spread is the compensation dealers
  and limit order traders receive for offering
  immediacy.
 The most important factor in order
  placement decision (market vs. limit orders)
 The most important factor in dealer’s
  liquidity provision decision
 The most important chapter of the book.
Dealer spreads
 Monopoly dealers
 Low barriers to entry in most markets
 In many markets, dealers face competition
  from public limit order traders
 Normal vs. economic profits – Dealers
  earn only normal profits in competitive
  dealer markets
Components of the spread
   Transaction cost component
     • Transitory spread component
     • Covers the normal costs of doing business,
       monopoly profits, risk premium
     • Responsible for bid-ask bounce
   Adverse selection component
     • Compensate dealers for losses to informed
       traders
     • Permanent spread component
Two explanations for adverse
selection component
   Information perspective
    •   The difference in the value estimates that
        dealers make conditional on the next trader
        being a buyer or a seller
   Accounting perspective
    •   The portion of the spread that dealers must
        quote to recover from uninformed traders
        what they lose to informed traders
Definition and assumption
V = the unconditional value of a security
P = the probability that the next trader is an
  informed trader
V+E = the value of the security when an
  informed trader wants to buy
V-E = the value of the security when an
  informed trader wants to sell
The next trader is equally likely to be a buyer
  or a seller.
Information model
Conditional expectation of the security value given
 that the next trader is a buyer
= (1-P)V + P(V+E) = V + PE

Conditional expectation of the security value given
 that the next trader is a seller
= (1-P)V + P(V-E) = V - PE

Adverse selection component of the spread
 = (V + PE) – (V - PE) = 2PE
Accounting model
Let B is the dealer’s bid price and A is the dealer’s ask price.

Conditional expectation of dealer profit given that the next
  trader is a seller
= (1-P)(V-B) + P[(V-E) - B] = V - B – PE.
Conditional expectation of dealer profit given that the next
  trader is a buyer
= (1-P)(A-V) + P[A - (V+E)] = A - V – PE.
Since the next trader is equally likely to be a buyer or a seller,
  the expected dealer profit is
= ½(V – B – PE) + ½(A – V – PE) = ½(A – B) – PE.

Finally, setting ½(A – B) – PE = 0, we obtain A – B = 2PE.
Uninformed traders lose to
informed traders
   When uninformed traders use limit orders
    • Informed traders trade on either the other side
      or the same side, depending on their private
      information.
    • Uninformed traders either regret trading or
      regret not trading.
   When uninformed traders use market orders
    • Pay large spreads (due to informed trading)
Determinants of equilibrium spreads
in continuous order-driven markets
   Information asymmetry among traders (+++)
   Time to cancel limit orders (++)
   Volatility (++)
   Limit order management costs (+)
   Value of trader time (+)
   Differential commission between limit and
    market orders
   Trader risk aversion (+)
Cross-sectional determinants of
equilibrium spreads – Primary
 Information asymmetry
 Volatility
    •   Limit order option values increase with volatility
    •   Inventory risks increase with volatility
    •   Asymmetry problem increases with volatility

   Utilitarian trading interest
    •   Utilitarian traders are uninformed - lower adverse selection
    •   High volume stocks have lower order processing costs, smaller
        inventory risks, more limit order trading, smaller timing option
        value, and more dealer competition
An example:
   I buy 100 shares of ABC. When I decide to buy the shares, the market is
    50 bid, 51 offered. I actually buy at 51.20, paying a $29 commission.

    Cash outflow = 5,120 + 29 = 5,149

   When I make the decision to sell, the market is 54 bid, 54.50 offered. I
    actually sell at 54, paying a $29 commission.

    Cash inflow = 5,400 – 29 = 5,371

   My net cash flow is 5,371 – 5,149 = 222. [A return of 4.31%(= 222/5,149)]

   In my paper portfolio, I buy and sell at the midpoint of the bid and ask
    quotes at the time I decide to trade.

   I buy 100 shares at 50.50 and sell at 54.25 = 375 (a 7.43% return)

   The implementation shortfall is 375 – 222 = 153 (ignoring interest)

   Alternatively, the implementation shortfall is 7.43% – 4.31% = 3.12%
    Further analysis
   The cost of a trade is explicit cost + implicit cost

        Explicit cost: commission (net of any rebates of goods or services,
        “soft dollars”)

        Implicit cost: the cost of interacting with the market.

        The initial purchase was made $0.70/sh above the BAM,
        so the implicit cost = $70

        The final sale was made $0.25/sh below the BAM,
        so the implicit cost = $25

    The implicit cost computed with respect to the BAM is the effective cost.

    The effective cost is a useful measure for market orders.
Effective cost
The effective spread

   Effective spread = 2 x effective cost
        For the initial purchase, the effective spread
        = 2 x $0.70 = $1.40 / share.

Intuition
 The quoted (posted) spread is 51 – 50 = 1. If a
 buyer pays $0.70 above the BAM and sells $0.70
 below the BAM, they are effectively facing a bid-
 ask spread of $1.40.
Realized cost and realized spread
 For executed trades, the realized cost is
  the transaction price relative to the BAM at
  some time subsequent to the trade.
 This impounds price movements after the
  trade (including the price impact due to the
  information in the trade).
Realized cost and realized spread
An interpretation of the realized cost
   This cost can be interpreted as the profit realized
    by the other (contra) side (e.g., dealer) of the
    trade, assuming the contra side could lay off the
    position at the new BAM.

Example
    • The dealer sells to the customer at 100.09.
    • Five minutes later, the market is bid 100.02, 100.12
      offered (BAM = (100.02+100.12)/2 = 100.07.)
    • The realized cost is 0.02.
    • This would be the dealer’s profit if he could reverse
      the trade (purchase the stock) at the subsequent BAM.
Summary
Quoted Spread = (Ask – Bid)
              = [(Ask – M) + (M – Bid)],

where      M = (1/2)(Ask + Bid)
             = the midpoint of the bid and ask.

Effective Spread = 2Abs(T – M) = 2D(T – M)
                 = 2 x Effective Cost,

where      T = the transaction price,
           D = +1 for customer buy order and
                -1 for customer sell order.
Price Impact = D(M+ – M).
Price Impact measures decreases in M following
  customer sells and increases in asset value
  following customer buys, which reflect the
  market’s assessment of the private information the
  trades convey. Such price moves constitutes a
  cost to market makers, who buy prior to price
  decreases and sell prior to price increases.

Realized Spread = Effective Spread - Price Impact
= 2D(T – M) - 2D(M+ – M) = 2D(T - M+)
= 2 x Realized Cost
= Market making revenue, net of losses to
  better-informed traders
Adverse selection model
           &
Components of bid-ask
       spreads
  (see lecture notes)
Chapter 20
 Volatility
Volatility
   Fundamental volatility is due to
    unanticipated changes in instrument
    values
    •   Price changes due to adverse selection
        spread component contribute to fundamental
        volatility
   Transitory volatility is due to trading activity
    by uninformed traders
Fundamental volatility factors
Unexpected changes in
 Interest rates and credit rating (bonds)
 Factors that affect firm value (stocks)
 National inflation rates, macroeconomic
  policies, and trade and capital flows
  (currencies)
 Cash market supply and demand
  (commodities)
Other factors that affect
fundamental volatility
 Storage costs
  High storage costs → small inventories
  → demand shocks → high price volatility
 Perishable goods
 Fundamental uncertainties
    •   High PE ratios, high political risks, highly
        leveraged firms
Transitory volatility
 Arises when the demands of impatient
  uninformed traders cause prices to diverge
  from fundamental values.
 These price changes are transitory because
  prices eventually revert to fundamental values.
 The transaction cost component of the bid-ask
  spread contributes to transitory volatility (i.e.,
  bid-ask bounce).
 Bid-ask bounce causes negative serial
  correlation in transaction price changes. See
  Roll’s model.
Chapter 24
Specialists
NYSE Structure

1366 members (specialists & floor brokers)
 Seat = Member = Right to buy & sell on
 the NYSE Floor
Approximately 3000 listed companies
NYSE
   The NYSE is a hybrid market. It has:
    •   floor traders (like a futures pit)
    •   an electronic limit order book (like Euronext)
    •   a designated dealer (the specialist) to maintain
        liquidity and otherwise coordinate trading.

   This mix is the outcome of political,
    technological and economic forces over the
    last 200 years.
NYSE   NYSE’s MarkeTrac: http://marketrac.nyse.com/mt/
Specialists
7 specialist firms
Approximately 450 specialists
Typically 5 to 10 years on-the-job training
Handle equities across all industries
Most individual specialists handle
 between 3 and 10 stocks
 Stocks
Each stock assigned to one firm
Stocks allocated one of two ways:
  •   Allocation interviews
        3-5Specialist firms participate in 30 minute
        interviews
              Either by phone or in person
  •   Assigned by NYSE Allocation Committee
Each stock trades at one location on floor
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 the spread is wide 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 also work orders entrusted to them
    by floor brokers. Specialists generally charge
    brokers commissions for these services.
   Specialists act as oral bulletin boards for brokers.
   Specialists have a responsibility to make sure
    that all traders follow the exchange rules.
    • Conduct an orderly market.
Specialists’ negative obligations
 Abide by order precedence rules, including
  public order precedence rule.
 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.
Specialist privileges
   Specialists can engage in:
    • Speculative trading on their own account
      based on their ability to predict short-term
      price changes
    • Quote-matching (see p. 249)
    • Cream-skimming - observe broker IDs for
      incoming market orders and step in front
      of the book by improving the price
    • 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.
Specialist Profitability: A
Challenging Environment

 Seat Prices Down 40% from highs
 Current return on Specialist Capital near
  zero
            $1,000,000
                         $1,200,000
                                      $1,400,000
                                                   $1,600,000
                                                                $1,800,000
                                                                             $2,000,000
                                                                                          $2,200,000
                                                                                                       $2,400,000
                                                                                                                    $2,600,000
                                                                                                                                 $2,800,000
12/1/2000

 1/1/2001

 2/1/2001

 3/1/2001

 4/1/2001

 5/1/2001

 6/1/2001

 7/1/2001

 8/1/2001

 9/1/2001

10/1/2001

11/1/2001

12/1/2001

 1/1/2002

 2/1/2002

 3/1/2002

 4/1/2002

 5/1/2002
                                                                                                                                                                        NYSE Seat Sales




 6/1/2002
                                                                                                                                              December 2000 - Present




 7/1/2002

 8/1/2002

 9/1/2002

10/1/2002

11/1/2002

12/1/2002

 1/1/2003

 2/1/2003

 3/1/2003

 4/1/2003

 5/1/2003
       Top Line Revenue Pressure
         QTRLY Specialist Revenues as a Percent of Volume
                            Annualized
2.5
                                                                           Pennies and
                                                                           Dow 12000
  2


1.5


  1

                                          Dow Loses 10%
0.5
                                                                 Source:
                                                                 NYSE Website and Bloomberg
  0
   7

          7

                 8

                        8

                               9

                                      9

                                             0

                                                    0

                                                           1

                                                                  1

                                                                         2

                                                                                 2

                                                                                         3

                                                                                                 3
  -9

         -9

                -9

                       -9

                              -9

                                     -9

                                            -0

                                                   -0

                                                          -0

                                                                 -0

                                                                        -0

                                                                               -0

                                                                                       -0

                                                                                                -0
1Q

       3Q

              1Q

                     3Q

                            1Q

                                   3Q

                                          1Q

                                                 3Q

                                                        1Q

                                                               3Q

                                                                      1Q

                                                                             3Q

                                                                                     1Q

                                                                                              3Q
 Specialist Return On Capital
                 (excludes NYSE Specialist Investigation Settlement Charges)

35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
        Source: NYSE Website

0.0%
     7

 1Q 7

 3Q 8

 1Q 8

 3Q 9
     9

 3Q 0

 1Q 0

 3Q 1

 1Q 1
     2

 1Q 2

 3Q 3
     3
   -9

   -9

   -9

   -9

   -9

   -9

   -0

   -0

   -0

   -0

   -0

   -0

   -0

   -0
 1Q

 3Q




 1Q




 3Q
Recent Controversy
 Issues surrounding former NYSE CEO Dick
  Grasso and SEC’s specialist investigation occur
  simultaneously
 Results:
  •   Reputation decline for NYSE
  •   Decline in market share
  •   Dual listing on NASDAQ of 7 stocks
  •   Dramatic decrease in NASDAQ transfers
 Despite these issues, NYSE still capturing bulk
  of IPO volume

								
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