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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
"Slide 1 - Personal websites at UB"