market liquidity

UniversityPressScholarshipOnline

OxfordScholarshipOnline

MarketLiquidity:Theory,Evidence,andPolicyThierryFoucault,MarcoPagano,andAilsaRoell

Printpublicationdate:2013PrintISBN-13:9780199936243PublishedtoOxfordScholarshipOnline:September2013DOI:10.1093/acprof:oso/9780199936243.001.0001

TitlePages

MarketLiquidityMarketLiquidityMarketLiquidity

(p.iv)

OxfordUniversityPressisadepartmentoftheUniversityofOxford.ItfurtherstheUniversitysobjectiveofexcellenceinresearch,scholarship,andeducationbypublishingworldwide.

OxfordNewYorkAucklandCapeTownDaresSalaamHongKongKarachiKualaLumpurMadridMelbourneMexicoCityNairobiNewDelhiShanghaiTaipeiToronto

Title Pages

WithofficesinArgentinaAustriaBrazilChileCzechRepublicFranceGreeceGuatemalaHungaryItalyJapanPolandPortugalSingaporeSouthKoreaSwitzerlandThailandTurkeyUkraineVietnam

OxfordisaregisteredtrademarkofOxfordUniversityPressintheUKandcertainothercountries.

PublishedintheUnitedStatesofAmericabyOxfordUniversityPress198MadisonAvenue,NewYork,NY10016

OxfordUniversityPress2013

Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans,withoutthepriorpermissioninwritingofOxfordUniversityPress,orasexpresslypermittedbylaw,bylicense,orundertermsagreedwiththeappropriatereproductionrightsorganization.InquiriesconcerningreproductionoutsidethescopeoftheaboveshouldbesenttotheRightsDepartment,OxfordUniversityPress,attheaddressabove.

Youmustnotcirculatethisworkinanyotherformandyoumustimposethissameconditiononanyacquirer.

LibraryofCongressCataloging-in-PublicationDataFoucault,Thierry.Marketliquidity:theory,evidence,andpolicy/ThierryFoucault,MarcoPagano,AilsaRell.p.cm.Includesbibliographicalreferencesandindex.ISBN978-0-19-993624-3(cloth:alk.paper)1.Liquidity(Economics)2.Securities.3.Capitalmarket.I.Pagano,Marco.II.Rell,Ailsa,1955-III.Title.HG178.F642013332.041-dc232012030772

ISBN978-0-19-993624-3

135798642PrintedintheUnitedStatesofAmerica

Title Pages

onacid-freepaper

Dedication





Dedication

(p.v) Toourfamilies(p.vi)

Preface





(p.xii) PrefaceLiquidmarketsenablepeopletofundinvestmentsthatrequirealong-termcommitmentofwealth,whileretainingtheopportunitytoaccessthatwealthwhenneeded.Inthiswayliquidityfacilitatesrealinvestmentandenhanceseconomicgrowth.Butmarketliquiditycanbeelusiveattimes,asinvestorsdiscoveredtotheircostintherecentfinancialcrisisaforciblereminderofJohnMaynardKeyness1936warningthatthereisnosuchthingasliquidityofinvestmentforthecommunityasawhole(p.155):marketsfreezewheneveryoneisseekingliquidityandnooneiswillingtoprovideit.

AimandStructureoftheBookThecentraltopicofthisbookistheliquidityofsecuritymarkets:itsdeterminantsanditseffects.Thefirstpartofthebook(Chapters1through5)providesthereaderwithbasicmodelingandeconometrictoolsneededtounderstandmarketmicrostructure,theareaoffinancialeconomicsthatfocusesonsecuritymarketliquidity.Thispartofthebookstartsbydescribinghowsecuritymarketsareorganizedandhowtheirliquiditycanbemeasured.Thenweexplainhowvariousmarketimperfectionsaffectpriceformation,liquidity,andspeedofpricediscovery.Finally,weshowhowtheinteractionoforderflowandpricemovementscanbeusedtoassessempiricallytherelativeimportanceofvariousdeterminantsofliquidity.

Preface

Thesecondpartofthebookinvestigateshowkeyfeaturesofmarketdesignaffectthelevelofliquidity,thespeedofpricediscovery,andgainsandlossestomarketparticipants:weexaminelimitorderbookmarketswithcontinuoustrading(Chapter6),andtheissuesoffragmentation(Chapter7)andtransparency(Chapter8).

Thethirdpartofthebookisdevotedtointeractionsbetweenmarketmicrostructure,assetpricing,andcorporatefinance.Wefirstexplainhow(p.xiii) liquidityaffectsthereturnsrequiredbyinvestors,andthereforeassetprices.Next,weexaminehowpricesinilliquidmarketsmaydivergefromunderlyinglong-runvalues,especiallyinthecontextofmarketfreezesandfinancialcrises(Chapter9).Thebookconcludesbyexplaininghowliquidityaffectsrealinvestmentdecisionsandcorporatepolicies(Chapter10).

Thebookprovidesanintroductiontothefieldofmarketmicrostructure,coveringtheory,empiricalwork,andpolicyissues.Itisdesignedasatextbookforintermediateandgraduate-levelstudentsineconomicsandfinance,aswellasforpractitionerswithsomeeconomicstraining.Theleveloftechnicalcomplexityiskepttoaminimum,sothatonlyaverybasicknowledgeofcalculus,statistics,andgametheoryisnecessarytotacklethematerial.Thebookdoesnotaimtobeacomprehensivesurveyofthefield,butaunifiedandself-containedtreatmentofthecoreconceptsandtechniquesinanareathathasgreatlydevelopedinthelastthirtyyears.Asthebookisintendedtobeateachingandlearningtool,eachchapterstartswithalistoflearningobjectivesmajorpointsthatthestudentcanexpecttomasterbyworkingthroughthechapter.Mostchaptersalsoincludeboxesthatdescribebusinessstoriesorquotesfromthefinancialpressthatillustratethereal-worldrelevanceoftheconceptsandresultspresented.Thebookalsocomeswithageneroussupplyofexercises,whichvaryincomplexityandfocus:someofthemrequireanalyticalderivations;othersaskforempiricalworkonsmalldatasetsprovidedonthebookscompanionwebsite(whichalsocontainssupplementalteachingmaterialforregisterededucators);seehttp://www.oup.com/us/marketliquidity/.Ourexperienceisthathands-onpracticewiththeend-of-chapterexercisesisthebestwaytomasterthematerialinthebook.

HowtoUsetheBookWecansaywithsomeconfidencethatthisisausefulbook,havingtaughtfrompreliminaryversionsofitovertheyears.Indeed,wehavegreatlybenefitedfromthefeedbackreceivedovermorethanadecadefromundergraduateandgraduatestudentsatHECParis,ImperialCollege,TinbergenInstitute,andattheuniversitiesofBologna,Mannheim,Naples,Princeton,Sydney,andTilburg.Thebookcanbeusedasthemainsourceofmaterialforacourseinmarketmicrostructureorasacomplementtootherbooksinotherareasoffinance.

Acoursethatcoverstheentirebookwouldrequirethirtytofortylecturehours,dependingonthebackgroundofthestudents(plusabouttenone-hourexercisesessions).However,thebookisdesignedtoallowamodularuseofitsmaterial:byacarefulselectionofchapters,itcanbeadaptedtoeitheranintroductorycourseinmarketmicrostructurepitchedatthelevelofan(p.xiv) advancedundergraduateormasterclass,oramorespecializedandadvancedcourse,possiblyatthedoctorallevel.More

Preface

specifically,herearesomeexamplesoftypicalcoursesthatcanbedesignedbyslicinganddicingthematerialinthebook:

(i)ForabasiccourseinmarketmicrostructurewewouldrecommendincludingallofPartI(fifteentotwentylecturehoursdependingonstudentsbackground).Thechaptersontheinstitutionalsetting(Chapter1)andthebasictheoryofpricedetermination(Chapter3)areessential.Thetheoryofmarketdepth(Chapter4)ishighlyrecommended,althoughashortcoursemightleaveoutthesectionsonimperfectcompetition.Abasicempiricaltrainingisprovidedbythechaptersonthemeasurementofliquidityandonestimatingthedeterminantsofliquidity(Chapters2and5).Ifmoretimeisavailable,anyofthesubsequentchapters(fromPartsIIandIII)maybecovered:eachofthemisself-contained,sothattheycanbechoseninanycombinationthatcaterstotheinterestsofthecourseparticipants.Eachadditionalchapterwouldrequirenolessthanthreelecturehours.(ii)Amaster-levelcourseonthearchitectureofsecuritiesmarketswouldstartwiththebasicinstitutionsandtheory(Chapters1,3,and4)andthenfocusonthemarketdesignandregulatoryissuesaddressedinPartII(Chapters6,7,and8).Suchacoursewouldrequirefifteentotwentylecturehours.(iii)Amaster-levelorPh.D.coursestressingtherelevanceofmarketmicrostructureforassetpricingandcorporatefinanceshouldincludeChapters3,4,9,and10(twelvetofifteenhours).(iv)AsuitablecomplementforaPh.D.courseinassetpricingwouldincludeChapters3and9.(v)Similarly,tocomplementaPh.D.courseincorporatefinance,wesuggestChapters3and10.

AcknowledgmentsThisbookhasbeenmanyyearsinthewriting,asourstudents,colleagues,andfamilymembersknowonlytoowell.Wehaveaccumulatedalargedebtofgratitude.Wewouldliketothankthecolleagues,coauthors,andmentorswhoinspiredandencouragedourworkinthearea.ApartiallistincludesViralAcharya,AnatAdmati,AlessandroBeber,BrunoBiais,PatrickBolton,MargaretBray,GiovanniCespa,HansDegryse,PeterDiamond,AndrewEllul,LaurentFresard,AlessandroFrino,ThomasGehrig,LarryGlosten,CharlesGoodhart,OliverHart,JoelHasbrouck,MartinHellwig,JohanHombert,CharlesJones,FrankdeJong,OhadKadan,EugeneKandel,MervynKing,PeteKyle,Albert(p.xv) Menkveld,SophieMoinas,TheoNijman,MaureenOHara,ChristineParlour,IoanidRosu,PatrikSandas,DuaneSeppi,ChesterSpatt,Ernst-LudwigvonThadden,ErikTheissen,DavidThesmar,DimitriVayanos,PaoloVolpin,andJosefZechner.

WeareparticularlygratefultoAlessandroBeberforprovidingdata,toAndrewEllulforbothdataandextensivefeedbackonthemanuscript,andtoLorenzoPandolfiforhisinvaluableadviceandhispainstakingworkontheexercises.Wealsothankthegraduatestudentswhoatvariousstagesprovidedvaluablefeedbackandassistance:Gennaro

Preface

Catapano,Chin-HanChiang,DincbasNeslihan,FrancescoPaoloConteduca,SarahDraus,MaurizioMontone,RobertoPinto,Jean-DavidSigaux,YuehuaTang,AntoineThabault,andespeciallyPaulWhelan.

SpecialmentiongoestoRogerMeserveyforhisoutstandingcopyeditingoftheentiremanuscript.ThestrikingcoverwasdesignedbyPaolaPagano,whotookthebookliterallyasaninspirationtofreezeafewliquidassets.WealsothankTerryVaughnandJoeJacksonatOxfordUniversityPressfortheirencouragementandguidanceduringthepreparationofthemanuscript.

Overtheyears,ourresearchforthisbookwassupportedbyourrespectiveemployers:coledesHautestudesCommercialesdeParis,UniversitdiNapoliFedericoII,ImperialCollegeLondon,andColumbiaUniversitysSchoolofInternationalandPublicAffairs.ExtendedperiodsofjointworkonthebookweregenerouslyhostedbytheItalianAcademyforAdvancedStudiesatColumbiaUniversity,theStudienzentrumGerzensee,theEinaudiInstituteforEconomicsandFinance,andtheToulouseSchoolofEconomics.

Lastbutnotleast,wethankAnne,Carla,andPatrickfortheirsupportandtheirpatienceinputtingupwiththecountlesshourswestolefromfamilytimetoworkonthisenterprise.

Introduction





Introduction

ThierryFoucault

MarcoPagano

AilsaRell

DOI:10.1093/acprof:oso/9780199936243.003.0001

AbstractandKeywords

Thisintroductorychapterbeginswithanoverviewofwhatthisbookisabout.Itidentifiestwokeyconceptsinmarketmicrostructuremarketliquidityandpricediscoveryandexplainswhytheseareimportant.Itthenoutlinessomepuzzlingphenomenainsecuritiesmarketsandconcludeswithadiscussionofthethreedimensionsofliquidity.

Keywords:marketmicrostructure,marketliquidity,pricediscovery,securitiesmarkets

LearningObjectives:

Whatisthisbookabout?

Twokeyconceptsinmarketmicrostructure:marketliquidityandpricediscovery

Introduction

Whydopeoplecareaboutmarketliquidityandpricediscovery?

Whichpuzzlescanmarketmicrostructureaddress?

Thethreedimensionsofliquidity

0.1.WhatisThisBookabout?Thewaysecuritiesareactuallytradedisfarremovedfromtheidealizedpictureofafrictionlessandself-equilibratingmarketofferedbythetypicalfinancetextbook.Inthatidealizedversionofthetradingprocess,allpotentialparticipantsarepresentonthemarket;theseparticipantsconveytothemarketordersthatreflecttheirdemandorsupplyofsecurities,andtheyarenotaffectedbyactionsofothermarketparticipants;andanauctioneerbalancesthequantitiesdemandedandsuppliedatasingleequilibriumpricethatreflectsaconsensusviewofthesecuritysfundamentalvalue.Real-worldmarketsdonotworklikethis,fortwomainreasons.

First,marketplayersarenotallsimultaneouslypresentonthemarket.Suchcontinuouspresencewouldbetoocostlyintime,attention,andaccesscosts.Atanygivenpointintime,priceformationisdelegatedtothelimitednumberofmarketparticipantswhohappentobepresent.Anytemporaryimbalancebetweenbuyandsellordersforasecuritywillhavetobeabsorbedbywhoever(p.2) ispresent,especiallybyprofessionalintermediarieswhospecializeinmakingthemarket.Typically,marketmakersandotherinvestorswillabsorborderimbalancesonlyifthepriceissufficientlyattractive.Forinstance,toabsorbaspateofsellordersinvestorswillrequiretheinducementofasufficientlylowprice.Asaresult,theequilibriumpriceactuallystruckatanygiveninstantmaydeviatefromtheonethatwouldemergeifallinvestorsparticipated.Thesepricedeviationsgenerateprofitopportunities,whichinturnwilldrawinmoretraders.Overtimethedeviationsareironedout.

Second,eventhelimitednumberofparticipantswhoarepresentatanyinstantinareal-worldsecuritymarkethavequitediverseinformationaboutthesecuritysfundamentals:someparticipantsareshrewdmarketprofessionalswithallthelatestnewsandstate-of-the-artpricingmodelsattheirfingertips;othersdonothavesuchup-to-dateinformationbutmaytrytoinferitfromthebehaviorofotherparticipants;stillothersmaytradeforreasonsthatareunrelatedtoinformation,forinstanceaneedtoliquidatetheirholdingsinordertopaytheirbills.Asaresult,theorderflowisacomplexmixofinformationandnoise,andaconsensuspriceonlyemergesovertime,asthetradingprocessevolvesandparticipantsinterprettheactionsofothertraders.Thisisanotherreasonwhyasecuritysactualtransactionpricemightdeviatefromitsfundamentalvalue,whichwouldbeassessedbyafullyinformedsetofinvestors.

Thisbooktakesthesedeviationsofpricesfromfundamentalvaluesseriously.Weexplainwhyandhowtheyemergeinthetradingprocess,andhowandwhytheyareeventuallyeliminated.Fortunatelywecandrawonavastbodyoftheoreticalinsightsandempiricalfindingsonsecuritypriceformationthathasbeenbuiltupinthelastthirtyyears,formingawell-definedfieldoffinancialeconomicsknownasmarketmicrostructure.Asweshallsee,thestudyofmarketmicrostructureilluminatestwokeyaspectsofreal-world

Introduction

marketsthatareneglectedbytextbookassetpricingmodels:liquidityandpricediscovery.

Liquidityisthedegreetowhichanordercanbeexecutedwithinashorttimeframeatapriceclosetothesecuritysconsensusvalue.Conversely,apricethatdeviatessubstantiallyfromthisconsensusvalueindicatesilliquidity:inanilliquidmarket,buyorderstendtopushtransactionpricesup,whilesellorderstendtodotheopposite;inextremecases,thedeviationissogreatthatitisnotworthwhileorfeasibletotradeatall,andthemarketfreezes.Inotherwords,inanilliquidmarket,thebestpriceatwhichasecuritycanbebought(askprice)isconsiderablyabovethebestpriceatwhichitcanbesold(bidprice).Andinfactthedifferencebetweenthesetwopricesthebid-askspreadisacommonmeasureofilliquidity.Liquiditydiffersgreatlyamongsecuritiesandovertime,oneoftheaimsofthisbookistoexplainwhythisisso.Forinstance,thefollowingtableshowsthebidandaskpricesatwhichdifferentU.S.stocks(p.3)

Table0.1BidandAskPricesQuotedforSelectedNYSE/NasdaqStocksonSeptember2,2010at4:20p.m.Stock IBM Amazon Barnes&Noble Borders Books-A-MillionBestbidprice 124.88 135.06 16.02 1.05 5.40Bestaskprice 124.89 135.14 16.10 1.06 5.94$bid-askspread 0.01 0.08 0.08 0.01 0.54%bid-askspread 0.01% 0.06% 0.50% 0.95% 9.52%

couldbesoldorboughtontheafternoonofSeptember2,2010.Clearly,thestockoflargecompaniessuchasIBMandAmazonisextremelyliquid,withbid-askspreadsintherangeofafewhundredthsof1percent.Incontrast,forasmaller,lesswellknowninternetbooksellerlikeBooks-A-Million,thespreadisnearly10percentasubstantialilliquiditycostforpotentialinvestors.

Liquidityalsofluctuatessignificantlyovertime.Duringthefinancialcrisis,theaveragebid-askspreadsforstockslistedonthemajorexchangesworldwideincreaseddramatically,fromabout3percentinthefirsthalfof2008to6percentinthesixmonthsfollowingthefailureofLehmanBrothersinSeptember.Theaveragespreadpeakedatover6.5percentintheperiodofgreatuncertaintyprecedingtheannouncementoftheCitibankrescueonNovember23.1Theconnectionbetweenuncertaintyandilliquidityisunderscoredbythefactthatitwasfinancialstockswhosespreadsincreasedthemostsharplybyfarduringthosemonths.Thespikesinbid-askspreadsonthestockmarketcoincidedwithevengreaterdisruptionsintheinterbankmarketandthemarketsforcreditdefaultswaps(CDS)andmanyasset-backedsecurities.Thelackofliquiditywassointensethatatsomepointsmarketssimplyseizedup.Thisbookexaminesandexplicatesthecausesofsuchdramaticchangesinmarketliquidity.

Pricediscoveryisthespeedandaccuracywithwhichtransactionpricesincorporateinformationavailabletomarketparticipants.Marketssometimesdisplayanastonishing

Introduction

abilitytolocateinformationaboutrecenteventsandextractitsimplicationsforunderlyingstockvalues.Forexample,inthewakeofthespaceshuttleChallengerexplosionat11:39a.m.ESTonJanuary28,1986,thestockmarketveryquicklydeterminedwhichofthefourpotentialcontractingmanufacturerswasatfaultforthedefectivepartsoftheshuttle:withinfifteenminutes,therewasasell-inducedNew-YorkStockExchange(NYSE)tradinghaltinthesharesofonlyonecompany,Morton-Thiokol.Bytheendofthedayitsshareshadfallenby11.86percent,whileLockheed,Martin-Marietta,andRockwell(p.4) fellbymuchless(MaloneyandMuhlerin,2003).Bycontrast,thegeneralpublicdidnotlearnofthecauseofthecrashuntiltwoweekslater,onFebruary11,whenNobel-winningphysicistRichardFeynmandemonstratedthattherewereproblemswithMorton-Thiokolsboosterrockets.Thisepisodeillustratesthemarketsabilitytocreateknowledgeoutofamultitudeofindividualtrades,eachofwhichmanagestocontributeasmallpieceofinformationtotheoverallpicture.Inthissense,securitiesmarketsareavehicleforamalgamatingunorganizedknowledge(MaloneyandMuhlerin,2003,p.474).

Thisepisodealsoillustratesageneralbutunintuitivepointthatwillreceiveconsiderableattentionhere,namely,thatthereisatensionbetweenpricediscoveryandliquidity.Whenprice-relevantinformationgetstothemarketbymeansoftradingpressureratherthanapublicannouncement,liquiditysuffers.Infact,justasitbecameapparentthatthesellordersofsomemarketparticipantsmightbebasedonsuperiorinformationaboutMorton-Thiokolsresponsibilityforthedisaster,themarketforitssharesbecamemostilliquid:theNYSEspecialistdealinginMorton-Thiokolsstockdecidedtohalttrading,toavoidmakingamarketinasituationwherehemightveryeasilylosemoneytoinformedtraders.

0.2.WhyshouldweCare?Whyismarketliquidityimportant?Assetmanagersandordinaryinvestorscareaboutliquidityinsofarasitaffectsthereturnontheirinvestments,simplybecauseilliquidsecuritiescostmoretobuy,andsellforless.Therefore,illiquid-ityeatsintothereturn.Whenmarketsarelessthanperfectlyliquid,investorscannotbuyandsellatthesameprice,andthebid-askspreadistypicallywiderforlargetrades.Thus,analysisofthewayliquidityarises,builds,orvanishesmaybeveryimportantinevaluatingtheportfoliochoicesofanassetmanageroranordinaryinvestor.

Forthesamereasons,liquidityisakeyconcernofalltheprofessionalswhospecializeinprovidingsecuritiestradingservices,suchasthetradingdesksofinstitutionalinvestors(mutualfunds,pensionfunds,andhedgefunds)andretailstockbrokers:locatingthemostliquidtradingvenueortimingtradessoastominimizetradingcostsisthekeytoprovidinggood-qualityservice.

Besidebeingasourceofcosts,thetradingprocesscanalsobeasourceofrisksforinvestors.Insofarasliquiditycanvaryovertimeinwaysthatarenotperfectlypredictable,itcanheightentheriskengenderedbytheunpredictabilityofassetsfundamentals.Soinvestorswillrequirecompensationnotonlyfortheexpectedtradingcostsassociatedwithilliquiditybutalsofortheadditionalrisks.Forbothofthesereasons,

Introduction

illiquidityaffectsequilibriumprices,whichmustdiscount(p.5) notonlyriskyfuturecashflowsgeneratedbytheasset,butalsothefuturetradingcoststhatitsholdersmayincurandtheassociatedrisks.Theneedtocompensateinvestorsforilliquiditycreatesalinkbetweenthefieldofmarketmicrostructureandthatofassetpricing,whichwewillexploreinChapter9.

Butifilliquiditylowerssecuritiesprices,affectingthecostofcapitalfortheissuers,thenitwillalsoaffectthesecompaniesday-to-daydecisionsoncapitalexpenditure.Therecentfinancialcrisisisatellingexampleofthelinkagebetweenmarketliquidity,assetpricesandeconomicactivity:thedryingupofliquidityinseveralsecuritiesmarketsin2008wasassociatedwithplungingassetpricesanddrasticreductionsinsecurityissuanceandrealinvestmentbyfirms.Andalthoughthesedropslargelyrepresentedacorrectionofpreviousoverpricingandover-investment,theilliquidityofsecuritiesmarketsundoubtedlyamplifiedtheeffectsoftherevisioninfundamentals.Thisepisodeillustrateswhypolicymakerstakesuchastronginterestintheliquidityofsecuritiesmarketsandinhowpoliciesandregulationsaffectit.

Investors,issuers,andpolicymakersnaturallycarenotjustaboutliquiditybutalsoaboutthespeedofpricediscovery.Thisdeterminestheamountofinformationthatatanyinstantisembodiedinthepriceofasecurity,andhencehowreliablethatpriceisasareferencepointformanagersrealinvestmentdecisions.Aninformationallyefficientpriceisalsousefulasabenchmarkforevaluatingtheperformanceofthefirmsmanagement,andfordevisingequity-andoption-basedcompensationschemesthatprovidetheproperincentives.Inshort,marketmicrostructureissuesprovetoberelevanttocorporatefinancechoices,onsuchmattersascapitalbudgetingandmanagementcompensation,asweshallseeinChapter10.

0.3.SomePuzzlesThisbookexplainsanumberofpuzzlingphenomenainsecuritiesmarkets.Letusconsiderafewspecificexamplesofissuesthatcanbeattackedandunderstoodusingtheanalyticaltoolsandempiricalmethodsofmarketmicrostructure.

(i)Whydoesliquiditychangeovertime?Aswehaveseen,securitiesmarketsbecamemuchmoreilliquidduringtherecentfinancialcrisis,especiallyinthesecondhalfof2008.ThisalsohappenedatthestartoftheGreatDepressionof192930,whentheaveragebid-askspreadonthestocksconstitutingtheDowJonesindexwidenedfromslightlyunder0.6percentbeforethecrisistoover1.4percent(figure0.1).ThefigurealsoshowsthatU.S.stockmarketliquidityhasbeenbasicallyincreasingsinceWorldWarII.Averagebid-askspreadsgraduallydeclinedfromabout0.6percentinthe1950stoabout0.2percentaround2000,withanespeciallylargedropinthe1990s.(p.6)

Introduction

Figure0.1. Averagepercentbid-askspreadofDowJonesstocks(Source:Jones,2002)

Moreover,liquiditychangessystematicallyinamuchmorelimitedtimeframeaswell:withinasingletradingday,bid-askspreadstendtofeatureaU-shapedpattern,higherattheopenandattheclosethanduringtherestofthetradingday.Inaddition,forindividualstocksliquiditytendstodropinconnectionwithspecialevents,suchastakeoverbattles,orinthewakeofotherdramaticprice-relevantevents,asexemplifiedbytheChallengerexplosionepisodediscussedabove.ThemodelsofsecuritypricedeterminationpresentedinChapters3and4offerinsightintothereasonsfortheselow-andhigh-frequencyempiricalregularities.(ii)Whydolargetradesmovepricesupordown,andwhyarethesepricechangessubsequentlyreversed?Oneofthemostwidelyobservedpatternsinsecuritiesmarketsisthatlargeordersknownasblocktradesputtemporarypressureonprices:largebuysdrivethemup,andlargesellspushthemdown.ThiswasalreadyapparentintheearlystudybyKrausandStoll(1972),whichanalyzes7,009blocktradesin402stocksontheNYSEfromJuly1,1968toSeptember30,1969.Justifiedbyadetailedanalysisoftradingbybuyingandsellingpartiesforasubsampleofblocks,theauthorsidentifysellordersasthosethatarepricedonadowntick(i.e.,belowtheprevioustransactionprice),andbuyordersasthosepricedonanuptick.Figure0.2showsthatthepricedropassociatedwithblocksales(E2)islargely(thoughnotentirely)offsetbyanupswing(E3)priortothesubsequentmarketclose.ThecausesofthesepatternswillbestudiedinChapter3.(iii)Whyissecuritiestradingconcentrated?Onerecurrentfeatureoffinancialmarketsistheagglomerationofsecuritiestrading:aspractitionerslike(p.7)

Introduction

Figure0.2. Pricepatternassociatedwithablocksale(Source:KrausandStoll,1972)

Figure0.3. Ratioofforeigntodomestictradingvolumeaftercross-listing(Source:Hallingetal.,2008)

tosay,Liquiditybegetsliquidity.Peopleliketotradeatthesametimeofdayandinthesamevenueasmanyothermarketparticipants.Forinstance,afteralistedcompanycross-listsitssharesonaforeignexchange,itsdomesticmarketappearstoexertagravitationalpullonthetradingvolumethatinitiallymovedabroadwhatpractitionerscallflowback.Figure0.3showsthatthemedianratioofforeignmarkettodomesticmarketvolumedeclinesgraduallyoverthesixtymonthsfollowingthecross-listing;thedropisespeciallymarkedinthefirst(p.8)year.Chapter7inquiresintothereasonsforthistendencyofliquiditytofeeduponitselfandtopersistovertime,anditsimplicationsfortheorganizationofsecuritiesmarkets.(iv)Whydosometraderswillinglydisclosetheirintendedtrades,andothershidethem?Sometradersreallykeeptheircardsclosetothechest,submittingtheirordersinawaythatdoesnotrevealtheirtruesize.Forexample,asChapter2demonstrates,theymaysubmithiddenorders.Alternatively,theymaygooff-exchangealtogetherandtradeondarkpools,

Introduction

whereordersarenotdisplayed.Ontheotherhand,sometradersoptforsunshinetrading;thatis,theypreannouncetheirtradingintentions.Chapter8analyzesmarkettransparency,explainingwhyitharmssometradersandbenefitsothers.(v)Whyaretheretemporarydeviationsfromarbitrageprices?Theabsenceofarbitrageopportunitiesisacentraltenetofasset-pricingtheory:assetsthatgenerateidenticalcashflowsmustcommandthesamemarketprice,sothatthereisnoopportunityforprofitablearbitragetrading.Nevertheless,thereareinstancesinwhichtheno-arbitrageconditionbreaksdownfornon-negligibleperiodsoftime.Forinstance,DevilleandRiva(2007)useintradaytransactiondatatostudywhyittakestimefortheFrenchindexoptionsmarkettoreturntono-arbitragevaluesafterdeviatingfromput-callparity.Similarly,deJong,Rosenthal,andVanDijk(2009)documentdeviationsfromtheoreticalpriceparityinasampleoftwelvedual-listedcompanies,sometimesknownasSiamesetwins.Thesearepairsofcompaniesincorporatedindifferentcountriesthatcontractuallyagreetooperatetheirbusinessesasasingleenterprise,whileretainingtheirseparatelegalidentitiesandexistingstockexchangelistings,asinthecaseofRoyalDutch/Shell.Thesecompaniesshouldtradeatthesameprice,yetfrom19802002theirpricesactuallydifferedsomuchthatsimpletradingrulescouldproduceabnormalreturnsofnearly10percentperannuminsomecases,afteradjustingfortransactioncostsandmarginrequirements.InChapter9weexplorewhythesedeviationscanpersist,andhowtheyrelatetomarketliquidity.

0.4.TheThreeDimensionsofLiquidity

0.4.1MarketLiquidity

Inthisbookweusethewordliquiditytoindicatetheabilitytotradeasecurityquicklyatapriceclosetoitsconsensusvalue,thatis,inthesenseofmarketliquidity.Butreadersneedtobeawarethatthisisonlyoneofthreeinterrelateddimensionsofliquidity.Preciselybecauseoftheirinterrelationship,thesethreedistinctdimensionsareoftenreferredtointerchangeablyinthecontextofthe(p.9) samediscourseinfinancialpressarticlesandpolicydiscussions.Thiscanbeconfusing,soitisusefultoclarifywhatliquiditymeansoutsidethecontextofsecuritytrading.

0.4.2FundingLiquidity

Whenreferringtobanksorcompanies,liquidityisgenerallytakentomeanhavingsufficientcashortheabilitytoobtaincreditatacceptableterms,tomeetobligationswithoutincurringlargelosses.Wecanrefertothisnotionasfundingliquidity.Maintainingadequateliquidityisparticularlyimportantforbanks,whichtypicallyengageinmaturitytransformation.Thatis,theyuseshort-termliabilities(bankdepositsorrepurchaseagreements)tofundlong-termassets(loanstocompaniesandhouseholds).Hence,tobeabletosatisfytheclaimsoftheirdepositorsorcreditors,theymustmaintainanadequatebufferofcashandshort-termassetsthatcanbereadilyliquidated.Bankshaveotheroptionsforgeneratingliquidity,suchassellingloans,borrowingfrom

Introduction

otherbanks,orborrowingfromacentralbanksuchastheU.S.FederalReserveortheEuropeanCentralBank.However,itcouldstillhappenthat,sayduetoalossofconfidenceinthebank,depositorsmaywishtowithdrawfundsinexcessofthebankscashreservesplustheamountitcanraisebysellingshort-termassets(suchastreasurybillsorcommercialpaper)orobtainingovernightcreditontheinterbankmarket.Suchabankrunisdescribed,infact,asaliquiditycrisis,andintheabsenceofsufficientliquidityprovisionbythecentralbank,thedistressedbankwillbedrivenintobankruptcyandforcedtoliquidateitsloanportfolio.

Fundingliquidityisrelatedtomarketliquidityinseveralways.First,bothhavevalueforthesamereason:peoplewanttoholdassetsthatcanbeimmediatelytransformedintoconsumption,asforinstancewhentheownersuffersashock(e.g.,ahealthproblemorlossofjob)ordiscoversanunforeseenopportunity(e.g.,averycheaplypricedhouseoraveryattractivebusinessproject).Sinceitishardtoinsureagainstsuchindividual-specificliquidityshocks,peopletrytoself-insurebyholdingdemanddeposits,whichtheycanwithdrawwithoutnoticeincaseofneed.Thatis,theyprizefundingliquidity.Bythesametoken,investorsvaluemarketliquidity,thatis,theypreferassetsthatcanbesoldquicklyincaseofneedatpricesnotfarfromtheirfundamentalvalue.

Second,fundingliquidityisitselfaprerequisiteformarketliquidity.Forinstance,marketmakersoftenneedaccesstocredittomaintainalargeenoughinventoryofthesecuritiesinwhichtheyaredealing,becausetheydonothaveenoughequity.Hence,themoreabundantandcheaperisthemarketmakersfundingliquidity,thegreateristheliquidityofsecuritymarkets,inthesensethat(p.10) investorswillbeabletotradesecuritiesinlargeramountsatbetterprices.Bythesametoken,acreditcrunchadropinfundingliquiditymayimpairtheliquidityofsecuritymarkets,byforcingmarketmakerstowidentheirbid-askspreadsandreducetheirordersizemaximum.Chapter9analyzestheeffectoffundingliquidityonpriceformationinsecuritymarkets.

Third,thecausalrelationscanalsobereversed.Thatis,marketliquiditymaybeaprerequisiteforfundingliquidity,becausesecuritytradersoftenmustpostmargins(i.e.,collateralintheformofcashorsecurities)tocovertheriskthattheymaynotbeabletopayforthesecuritiestheyarebuyingordeliverthosetheyareselling.Thiscounterpartyriskcanariseifthetraderborrowsinordertobuythesecurity,orsellsshort(i.e.,withoutowningityet).However,marginrequirementsdependinpartonthesecuritiesexpectedmarketliquidity:theyaretypicallylowerforsecuritiesthatareexpectedtobemoreliquidandlessvolatile.Hencemoreliquidmarketsenabletraderstofundtheirleveragedpurchasesorshortsalesmorecheaply.Thiscreatesafeedbackfrommarketliquiditytofundingliquidity.

Thisreciprocalfeedbackbetweenmarketandfundingliquiditybecomesparticularlyimportantintimesofcrisis,whenitcanleadtoliquidityspirals,withmarketliquiditysuddenlydryingupformanysecuritiesatonce,asshownbyBrunnermeierandPedersen(2009).Itisimportanttorealizethat,howeverdeepandstrongtherelationshipbetweenthem,marketliquidityandfundingliquidityaredifferentnotions,andareaccordinglyaffectedbydifferentpolicyactions:marketliquiditybysecuritymarket

Introduction

regulationandfundingliquiditybybankingregulation,specificallybytheroleofthecentralbankaslenderoflastresort.Thisbringsustoathirdpossiblemeaningofliquidity,thatis,themonetarydimension.

0.4.3MonetaryLiquidity

Ifwerankassetsbymarketliquidity,themostliquidisobviouslycash,whichbydefinitionisuniversallyacceptedinexchangeforgoodsatverystableterms(exceptintimesofhyperinflation).Atintermediatelevelsofliquidityarefinancialsecuritiessuchasbondsandstocks,whileattheoppositeextremeisrealestate,whichissoheterogeneousthatsaletypicallyrequiresconsiderabletimeandeffort,orelsealargepriceconcessioninexchangeforquicksale.

Thisexplainswhyinpracticeliquidityisoftenidentifiedwithmoneyitself,whetherdefinedasthecashheldbyhouseholdsandfirmsandbankreserves(monetarybase),orasbroadermonetaryaggregatesthatalsoincludebankdepositsofvarioustypes(M1,M2,orM3).Especiallyinmacroeconomics,thisnotionofmonetaryliquidityisprevalent.Thisnotionofliquidityalso(p.11) bearssomerelationshiptotheprevioustwo:expansionofthemoneysupplybythecentralbank(say,viaopenmarketpurchasesofbondsorquantitativeeasing)increasesthesupplyoffundstobanksandthustendstoincreasefundingliquidity,andwithitmarketliquidity,aswehaveseen.Bythesametoken,amonetarycontractioncanbeexpectedtoreducebothfundingandmarketliquidity.Thereisavastliteraturethatanalyzesanddocumentsthelinkbetweenmonetarypolicyandfundingliquidity(seeBernankeandGertler,1995).Expansionarymonetarypolicymayincreasebanksloansupplyeitherdirectly(banklendingchannel)orindirectlybyimprovingborrowersnetworthandtherebytheirborrowingcapacity(balance-sheetchannel).Monetarypolicyhasalsobeenshowntoaffecttheliquidityofsecuritiesmarkets:attimesofcrisis,monetaryexpansionisassociatedwithgreaterliquidityinbothstockandbondmarkets,andbondmarketliquidityisforecastbymoneyflowstogovernmentbondfunds(Chordia,Sarkar,andSubrahmanyam,2005).

Ofcourse,theserelationshipsareneithermechanicalnorstableovertime,becausebanksandotherfinancialintermediariescangeneratedifferentamountsoffundingliquidityinthepresenceofthesamelevelofmoneysupply.Andconversely,theymayrespondtoanexpansionofthemonetarybasebyincreasingtheirreserveswiththecentralbankratherthanbyincreasingtheirlending.(p.12)

Notes:

(1.)ThesenumbersaredrawnfromBeberandPagano(2013),whoanalyzedailyclosingbidandaskpricesfor16,491stockslistedontheexchangesoffrom30countriesandpresentintheDatasteamdatabase.

Trading Mechanics and Market Structure





TradingMechanicsandMarketStructure

ThierryFoucault

MarcoPagano

AilsaRell

DOI:10.1093/acprof:oso/9780199936243.003.0002

AbstractandKeywords

Thischapterdiscussestheorganizationofsecuritiesmarkets.Atradingmechanismdefinestherulesofthegamethatmarketparticipantsmustfollow:itdeterminestheactionstheycantake,theirinformationaboutothermarketparticipants'actions,andtheprotocolformatchingbuyandsellorders.Tradingmechanismscanessentiallybeviewedasvariationsoftwobasicstructures:limitordermarketsanddealermarkets.Section1.2describeshoweachmechanismoperates,illustratesmarketstructuresthatcombineelementsofboth,andshowsthateachprototypicalmechanismitselfcanvaryinimportantways,suchasthedegreeoftransparencyandthefrequencyoftrades.Section1.3previewssomeempiricalstudiesthatcomparelimitorderanddealermarketsorinvestigatemarketswithdifferentdegreesoftransparency.Section1.4discussestheevolutionofmarketstructure.Thefinalsectionsprovidesuggestionsforfurtherreading


andexercises.

Keywords:securitiesmarkets,tradingmechanisms,marketstructure,limitordermarkets,dealermarkets

LearningObjectives:

Howsecuritiesmarketsareorganized

Whosetstherules

Howtheorganizationofsecuritiesmarketshaschangedrecently

1.1.IntroductionSecuritiesmarketsaremechanismsforbringingbuyersandsellerstogetherandenablingthemtotrade.Tradingmaybepromptedbyvariousfactors:theneedtomitigaterisks(hedging),thedesiretoexploitsuperiorinformation(speculation),ortheurgetorebalanceonesportfolio(liquidityshocks).Instandardtreatmentsofassetpricing,suchasthecapitalassetpricingmodel(CAPM),thetradingmechanismisnotlaidoutexplicitly,ontheassumptionthatitdoesnotmatterforsecuritiesprices.Yetinrealitythereisawidevarietyoftradingmechanisms,andmarketparticipantspaycloseattentiontotheirdesign.Changesintradingrulesareoftenhotlydebated,andmarketorganizerscarefullyfine-tunetheserulestoimprovethecompetitivenessoftheirtradingplatform.Thisisbecausethetradingrulesaffecttheefficiencyofmarketsasmechanismstorealizetradinggainsanddiscoverassetvalues.Theyalsoaffecttheapportioningofgainsamongmarketparticipants,determining,forinstance,thefractionofthegainthatiscapturedbyspecializedintermediaries.

(p.16) Atradingmechanismdefinestherulesofthegamethatmarketparticipantsmustfollow:itdeterminestheactionstheycantake(e.g.,thekindsoforderstheycanplace),theirinformationaboutothermarketparticipantsactions(e.g.,whethertheyobservequotesororders),andtheprotocolformatchingbuyandsellorders(e.g.,whetherordersareexecutedatacommonpriceornot).Asthepossiblerulescanbeputtogetherinavirtuallyboundlessnumberofcombinations,real-worldmarketstructuresfeaturegreatdiversityandareconstantlyevolving,soattemptingacompleteclassificationishopeless.Itismorefruitfultofocusontwoprototypetradingmechanisms,namelythelimitordermarket(orauctionmarket)andthedealermarket.1Infact,alltradingmechanismscanbeviewedasvariationsofthesetwobasicstructures.Inlimitordermarketsthefinalinvestorsinteractdirectly;theirbidsandoffersareconsolidatedinalimitorderbook(LOB)accordingtopricepriority,sothathigherbidsandcheaperoffersaremorelikelytobeexecuted.Bycontrast,indealermarketsfinalinvestorscanonlytradeatthebidandaskquotespostedbyspecializedintermediaries,calleddealersormarketmakers,andthesequotesarenotconsolidatedtoenforcepricepriority.Section1.2describeshoweachmechanismoperates,illustratesmarketstructuresthatcombineelementsofboth,andshowsthateachprototypicalmechanismitselfcanvaryinimportantways,suchasthedegreeoftransparencyandthefrequencyoftrades.

Thesedifferencesinmarketdesignarenotinconsequential,andmuchofthisbookdistills


theresultsofthelargebodyofresearchonhowmarketdesignaffectstradingcostsandpricediscovery.Toprovideanideaoftheimpactthatthedesignofsecuritymarketscanhaveontheirperformance,section1.3brieflypreviewssomeempiricalstudiesthatcomparelimitorderanddealermarketsorinvestigatemarketswithdifferentdegreesoftransparency.

Anobviousquestioniswhyinpracticemarketsfeaturedifferenttradingmechanisms.Assection1.4explains,tradingrulesaredeterminedbyinterplaybetweenregulators,intermediaries,issuers,investors,andthemanagersoftradingplatforms.Thebalancebetweenthesestakeholdersandhencetheactualtradingruleslargelydependsonthegovernanceandownershipoftheplatform.Forinstance,theplatformmaybemanagedforprofitornot,andtheownershipsharesofthevariousstakeholders(intermediaries,issuers,investors)mayvaryconsiderablybetweenplatformsandovertime.Andthedesignofatradingplatformmustalsotakeintoaccountthepossiblethreatfromcompetingplatformsaconcernthatinrecentdecadeshasbecomemorepressingduetoacombinationofcapitalmarketliberalization,changesinsecurityregulation,andtechnologicaladvances.Inparticular,digitalandcommunicationtechnology(p.17) hasradicallytransformedthetradingprocess,sparkinganincreasinglylivelydebateontheimpactofnewtradingtechnologiesonmarketliquidity,pricevolatility,andeconomicefficiency.

1.2.LimitOrderMarketsandDealerMarketsLimitorderorauctionmarketsarecentralizedtradingmechanismsinwhichpotentialparticipantscanshowtheirinterestintradingbysubmittingorders,whichthenarematcheddirectlybytradingplatforms.TypicalexamplesaresuchelectronictradingplatformsforequitiesasBATSintheUnitedStatesorChi-XinEurope.Attheoppositeextreme,alltradesindealermarketsareintermediatedbyprofessionalintermediariesthatquoteaskprices,atwhichthepubliccanbuysecuritiesfromthem,andbidprices,atwhichthepubliccanselltothem.Thatis,buyersandsellersdonottradedirectlywitheachother.AgoodexampleisthecorporatebondmarketintheUnitedStatesandinEurope.Thesearetypicallyover-the-counter(OTC)markets,wherebrokersmustshoparounddealerstogetthebestpricesanddealershavenoobligationtopostcontinuoustwo-wayquotes.

Actually,manysecuritiesmarketsarehybrid,combiningfeaturesofthesetwobasicmechanisms.Forinstance,theEuropeantradingplatformofNYSE-Euronextisorganizedasalimitordermarket,butforsomestocksitallowsdesignateddealerstopostquotesdirectly.Inotherexchanges,auctionanddealermechanismsareusedsidebysidefordifferentsecuritiesorfordifferentsetsofinvestors.Forinstance,theLondonStockExchange(LSE)hasdifferenttradingmechanismsaccordingtoastockstradingvolumeandmarketcapitalization:ahybridtradingplatform(SETS)thatcombinesalimitordermarketwithmarketmakingfortheliquidstocks,andadealermarket(SEAQ)forfixedincomesecuritiesandlessliquidstocks.

Bothmarketstructureshaveaprice-settingmechanismthatbalancesthedemandandsupplyforasecurity.Inthissense,theydifferfromelectroniccrossingnetworks(e.g.,


POSIT),whichaccumulatebuyandsellordersandcrossthemperiodicallyatthepriceobservedonsomeotherplatform(e.g.,theNYSE).

1.2.1LimitOrderMarkets

Aswehaveseen,adefiningfeatureofthelimitordermarketisthatbuyandsellordersfromfinalinvestorsarematcheddirectlyinasinglemarketplace,whichcanbeeitherthefloorofanexchangeoravirtualtradingvenuerunby(p.18)

Figure1.1. Limitordermarket

acomputer.OrdersgointoanLOB,whichdeterminestheprioritywithwhichtheywillbematchedwithoffsettingorders,accordingtotherulesofthemarketandthecharacteristicsoftheordersthemselves.Incall(orbatch)markets,incomingordersarestoredintheLOBandthenmatchedatdiscreteintervals,suchasonceperday.Incontinuousmarkets,theyarematchedimmediatelywithordersalreadypresentontheLOB,ifpossible;otherwisetheyarestoredintheLOBtoawaitfutureexecution.

ContinuousLimitOrderMarketsWhensubmittingorderstoacontinuouslimitordermarket,investorscandesignthemdifferentlydependingontheirtradingneeds.Themostbasicchoice,whichdeterminesbothspeedandpriceofexecution,isbetweenlimitandmarketorders.Abuylimitorderspecifiesthemaximumpriceatwhichthetraderispreparedtobuyastatedamountofthesecurity;similarly,aselllimitorderspecifiestheminimumpricethesellerwillacceptforagivenamount.Amarketorderonlyspecifiesanamounttobuyorsell,nottheprice:itwillthereforebeexecutedatwhateverpriceitcanfetchonthemarket.

Limitordersmaynotfindacounterpartwithwhichtheycanbematchedatthespecifiedprice.Marketorders,bycontrast,arefilledimmediatelyifthereisanyoutstandinglimitorderontheothersideofthemarket.Thus,onedifferencebetweenlimitandmarketordersisthatlimitordersdonotguaranteeimmediateexecutionindeed,theymayneverbeexecutedatallwhereasmarketordersareexecutedimmediatelyuponsubmission.

TheLOBshowninfigure1.2illustratesthemechanicsoftradinginacontinuouslimitordermarket.TheLOBisasnapshotatagivenpointintimeofallthelimitordersawaitingexecution.IntheLOB,weseethelimitordersonthebidandasksides:buylimitorders


(bids)arearrangedindecreasingorderofprice,selllimitorders(asks)inincreasingorder.TheLOBalsoshowssizeandtime,thatis,thenumberofsharesspecifiedandthetimetheorderwas(p.19)

Figure1.2. Exampleoflimitorderbook(LOB)

enteredinthebook.Dependingonthemarketstradingrules,onlyasubsetoftheorderspresentintheLOBmaybevisibletomarketparticipants.Asweshallseelater,thisisonedimensionofmarkettransparency.

Consideraninvestorwhowantstobuyninehundredshares.Hehastwooptions.Oneistoplaceabuymarketorderforthisamount.Inthiscase,theorderisexecutedimmediatelyagainstthebestlimitorderstosell(ontheaskside):itwillfirstfillthetwolimitordersplacedattheofferpriceof$74.48foreighthundredshares,andthenbeexecutedfortheremaininghundedsharesagainstthelimitorderat$75.74,sothatitsaverageexecutionpriceis$74.62.Notethattheorderofpriorityinwhichlimitordersonthebookareexecuteddependsontheirprice:aggressivelypricedordersarefilledbeforelesscompetitiveones.Inotherwords,executionobeysapricepriorityrule.Iftwolimitordershavethesameprice,theyarefilledaccordingtosecondarypriorityrulessuchastimeofsubmissionorpro-rataallocation(fractionalexecutionproportionaltolimitordersize).

Thesecondoptionfortheinvestoristoplaceabuylimitorderforninehundredshares.Ifhespecifiesalimitpricelowerthan$74.48,theorderisenteredintheLOBonthebidsideandstoredforfutureexecution.Thelevelofthechosenbidpricedeterminesthelikelihoodandspeedofexecution,asmoreaggressivelypricedbuyordersareexecutedfirstaccordingtopricepriority.

Iftheinvestorinsteadspecifiesalimitpriceequaltoorhigherthan$74.48thatis,ifhematchesorcrossesthebestpriceontheasksideofthelimitbookthentheorderismarketable:itcanbeexecutedatonce,atleastpartially,(p.20) againststoredselllimitorders,inthisexamplethoseat$74.48.Iftheorderspecifiesalimitpriceof$74.50,theremaininghundredshareswillappearonthebidsideoftheLOBasabuylimitorderat$74.50.Significantly,thetransactionprice($74.48)isdeterminedbyexistingpricesontheLOB,notbythepriceoftheincomingmarketablelimitorder.


Thetreatmentofsellersisanalogous.Forinstance,aninvestorwhowantstoselltwohundredsharesimmediatelycaneitherplaceamarketsellorderfortwohundredsharesoramarketablelimitorderwithapriceof$74.42orless.Ifheismorepatient,hecanimprovehisexecutionbyplacingaselllimitorderfortwohundredsharesatapriceabove$74.42,ontheasksideofthemarket.Butinthiscaseherunstheriskofnon-execution.

Hence,thechoicebetweenamarketandalimitorderinvolvesatrade-offbetweenimmediateexecutionatcurrentmarketpricesandamorefavorabletransactionpriceatthecostofdelayedanduncertainexecution.Thistrade-offisstudiedindetailinChapter6.

Figure1.2canalsobeusedtoillustratethenotionofilliquidity,whichisdiscussedinChapter2.Asathoughtexperiment,consideraround-triptransaction,thatis,abuymarketorderfollowedbyanequal-sizesellmarketorder.Ifthemarketwereperfectlyliquid,thecostofthisround-triptransactionwouldbezero.Instead,thefigureshowsthatithasapositivecostthatincreaseswithitssize.Iftheordersizeissmallerthanthreehundred,onebuysat$74.48andresellsat$74.42,sothattheround-tripcostis$0.06(i.e.,sixcents).Thiscostthedifferencebetweenthebestbidandthebestaskpriceonthemarketiscalledthequotedbid-askspreadandisoftenusedasameasureofilliquidity.

Forlargerorders,onecancomputeasimilarmeasureofilliquiditybycomparingtheaveragepricepaidbyabuyerplacingalargemarketorderandtheaveragepricereceivedbyasellerforanequallylargeorder.Thebuypriceriseswithordersize,becausethebuyerhastowalkupthescheduleofselllimitorderstofillhisownbuyorder.Symmetrically,thesellpriceisdecreasingwiththesizeoftheorder,asthesellerhastowalkdownthescheduleofbuylimitorders.Thuslargerordersareassociatedwithagreaterdifferencebetweentheaverageexecutionpriceforbuyandsellmarketorderstheweightedaveragebid-askspread.2Amarketinwhichinvestorscantradelargequantitieswithoutsubstantiallymovingthepricethatis,wheretheweightedaveragebid-ask(p.21) spreaddoesnotincreasemuchwithtradesizeissaidtobedeep.Therefore,marketdepthisinverselyrelatedtotheweightedaveragespreadforlargetradesize.ThenotionofdepthwillbemademorepreciseinChapter4.

TheLOBevolvesinrealtimeasmarketandlimitordersaresubmittedandearlierlimitordersarecancelled.Forinstance,inourexample,thesubmissionofabuymarketorderforninehundredsharesdepletestheLOBontheasksideandsowidensthebid-askspreadfrom0.06to1.58.Bycontrast,ifthebuyersubmitsalimitorderat$74.45,thebid-askspreadnarrowsto0.03.Sincemarketorderswidenthespread,theyareviewedasconsumingliquidity,andtraderssubmittingtheseordersarecalledliquiditydemanders(orliquiditytakers).Incontrast,thosesubmittinglimitordersarecalledliquiditysuppliers(orliquiditymakers),sinceaggressivelimitordersreplenishtheLOB.


Limitandmarketordersarebyfarthemostcommonkindsoforder.Buttradingplatformsoftenalsoallowformorecomplexorders.Astoporderisaninstructiontobuy(orsell)onlyoncethepricehasrisento(fallento,respectively)acertainlevel.Astopsellordercanbeusedtolimitoneslossesonholdingastockifitspricenosedives.Moreover,traderscansetconditionsoncancellationwiththeirorders:good-until-cancelordersarevaliduntiltheyarecancelled,whilegood-untilordersarevaliduntilaspecifieddateandimmediate-or-cancel(orfill-or-kill)ordersarevalidonlyatthemomenttheyreachthemarket.Finally,hiddenordersarelimitordersthatarestoredintheLOBbutnotdisplayedtomarketparticipants.Theseorderswillbeexecutedinthesamewayasregularlimitorders,buttheyusuallylosetimepriorityagainstlimitordersthataredisplayedatthesameprice.Avariantofthehiddenlimitorderistheso-calledicebergorder,forwhichafractionoftheactualsizeisshowntoothermarketparticipantsalongwiththeprice.Astheorderisexecuted,thehiddensizebecomesgraduallyevidenttomarketparticipants.

CallLimitOrderMarketsSofarwehaveconsideredlimitordermarketswithcontinuousmatching.Anotherarrangementmatchesordersatdiscretepointsintimesay,onceaday.Inthiscasethelimitordermarketisknownasacall(orbatch)auction.(p.22) Beforethecallauctionisheld,marketandlimitordersgraduallyaccumulateintheLOBunlesscancelled.AformalanalysisofpriceformationincallmarketsisprovidedinChapter4.

Inacallauction,thedeterminationofthepriceatwhichordersareexecuteddiffersfromthatofthecontinuouslimitordermarketdescribedinsection1.2.1.Inthiscase,allexecutableordersareclearedatthesameprice.Forthisreason,thecallauctionissometimescalledasingleoruniformpriceauction.

Moreprecisely,atthetimeofthecallauction,allthebuyordersinhandaresortedindecreasingorderoflimitprice,withbuymarketorderstreatedasatthehighestpossibleprice.Thisdeterminesthecumulativequantitythattradersarepreparedtobuyateachpossibleprice.Symmetrically,thesellordersaresortedbyincreasinglimitprice,withsellmarketorderstreatedasatthelowestpossibleprice.Thisdeterminesthecumulativequantitythatwouldbesoldateachpossibleprice.Theresultingdemandandsupplyfunctionsarethetwostepwiseschedulesshowninfigure1.3.

Thepricesetintheauctionthemarket-clearingorequilibriumpriceisdeterminedbythepointwherethesetwostepwiseschedulesintersect.Atthisprice,ordersfromallbuyerswithabidhigherthantheclearingpriceandallsellerswithapricebelowthatclearingpricearefullyexecuted.Limitorderswithapricejustequaltotheclearingprice(themarginaltraders)maybepartiallyexecuted.Forinstance,infigure1.3,thetotaldemandattheclearingpriceexceedsthetotalsupply,sothemarginalbuyerwillgetonly

Box1.1OtherTypesofOrder


partialexecution.Buylimitordersbelowtheclearingpriceorsellordersaboveitarenotfilled.Itiseasytoseethattheclearingpricemaximizesthe(voluntary)tradingvolume,asitleavesnotradingopportunityunexploited.

Inthepast,manyexchangesincontinentalEuropewereessentiallycallmarkets.Walras(1874)wasinspiredbythemechanismoftheParisBourse

Figure1.3. Callauction

(p.23)

Figure1.4. Formingtheinitiallimitorderbookofthetradingday

callauctionwhenheformalizedtheprocessbywhichsupplyanddemandarebalancedincompetitivemarkets.Today,withtheadventofcomputerizedtrading,thecallmechanismservesmainlytodeterminetheopeningpricebeforethestartofcontinuouslimitordertradingontradingplatformssuchastheNYSE-Euronext,LSE,ItalianStockExchange,andMadridStockExchange.Inthiscase,thelimitordersunfilledattheopeningcallauctionformtheinitialLOBforthecontinuoussession.Figure1.4showsthisinitialLOBinthecaseofthecallauctiondisplayedinfigure1.3andillustratesthatthebid-askspreadontheLOBincreaseswithtradesize,asnoted.Somemarketsalsousethecallauctiontosettheclosingpriceattheendofthetradingday.

Callauctionsareusedastheonlytradingmechanismforstocksthataretradedinfrequently.Inthisway,marketorganizersmakesurethatthereissufficientinterestonbothsidesofthemarket.Theyincreasethelikelihoodoffindingacounterpartforeachsidewhilereducingtheriskthattheclearingpricewillbedistortedbyatemporary


imbalancebetweensupplyanddemand.Forinstance,ontheLSE,SETSqxisatradingplatformthatrunsfourelectronicauctionsaday(alongsideadealermarket)forsecuritiesthatarelessliquidthanthosetradedonSETS.

1.2.2DealerMarkets

Indealermarkets,thefinalinvestorsdonottradedirectlywitheachother,butmustcontactadealer,findouthisprice,andtradeatthisprice,orelsetryanotherdealer.Soinadealermarketthereisasharpdistinctionbetweenliquiditysuppliers(thedealers)andliquiditydemanders(finalinvestors),whereasinalimitordermarketeachparticipantchooseswhethertoprovideortodemandliquidity.(p.24)

Figure1.5. Dealermarket

Figure1.6. Dealersbidandaskquotes

Figures1.5and1.6illustratethetradingprocessinadealermarket.Asanexample,supposethatSeller4wantstosellsixtysharesandthathefirstcontactsdealerBeta.Asshowninfigure1.6,Betaiswillingtobuyat$324andsellat$330.Seller4canthendecideeithertosellat$324ortoseekanotherdealer.Inthefirstcase,BetafillsSeller4sorderbybuyingthesecurityandaddingittohisinventory.ThisexposesBetatotheriskofasuddenfallinthepriceofthesecurity,andhencealossonthevalueofhisinventories.Toavoidthisinventoryrisk,Betacaneitherrebalancehispositionbytradingwithacustomerwhowantstobuythesecurity(forinstance,Buyer3inthefigure)orhecancontactotherdealerstosellthempartorallofhisposition.Aswewill(p.25) seeinChapter3,themanagementofinventoryriskisamajordeterminantofbidandaskprices.

Thus,wecandistinguishtwodifferentsegmentsindealermarkets:theretailsegment,in


whichdealersservefinalinvestors,andawholesalesegment(theinterdealermarket),inwhichdealerstradewitheachothertoshareinventoryrisk.ExamplesofinterdealermarketsaresuchtradingplatformsasEBSandReutersD2000/3000(intheforeignexchangemarket).Thevolumeoftradeontheinterdealermarketistypicallymuchlargerthanontheretailmarket,aseachtradewithagivenclienttricklesdowntootherdealersuntilitispassedontofinalinvestorsontheoppositesideofthemarket.Forinstance,a2001surveyoftheBankofInternationalSettlementsfoundthatinterdealertradingaccountsforabout80percentofallforeignexchangemarketvolume.

Inadealermarket,unlikealimitordermarket,thereisnoenforcementofpricepriority:inourexample,Seller4tradeswithBetaeventhoughhecouldobtainabetterpricefromAlpha.Thisisbecausequotesarenotnecessarilydisplayedtofinalinvestors,whomustfindthebestpricebycontactingdealersbyphoneormessagingsystems.Thissearchiscostly;ittakestimeandeffort.

However,wheninformationonquotesispubliclyavailable,marketparticipantscanidentifythedealerswhopostthebestbidandaskprices.Insomedealermarkets,suchasNasdaqandtheSEAQtradingplatformoftheLSE,thedealersquotesaredisplayedonscreensprovidingreal-timeinformationsimilartothatinfigure1.6.Inthisexample,nosingledealerquotesabid-askspreadoflessthan4,butthespreadresultingfromtheconsolidationofthequotes(sometimescalledtheinsidespreadormarkettouchintheUnitedKingdom)is329326=3,asisshownatthetopofthepanel(whichalsotellsuswhich,andhowmany,marketmakersquotethebestpriceoneachsideofthemarket).Thus,themarketasawholeoffersmoreliquiditythananyindividualdealer.

Manydealermarkets,however,offerfarlessdetailondealersquotes.Forinstance,noreal-timeinformationisavailableinOTCmarketssuchastheU.S.corporatebondmarket.Incurrencymarkets,theReutersandBloombergscreensdogiveinformationonquotes,butitisonlyindicative;thequotesdonotcommitdealerstoactuallytradeatthoseprices.

Dealersquotesaretypicallyvalidonlyforalimitednumberofshares.Soalargeordermaybeexecutedbysplittingitamongseveraldealers.Supposethatasellerwishestosellthreehundredsharesgiventhedealersquotesinfigure1.6.Hecanexecutethisorderbysellingseventy-fiveshareseachtodealersAlphaandZeta,whopostthebestbidprice,andthenanotherseventy-fiveeachtoGammaandLambdaatthenextbestbidprice.Effectively,theinvestoriswalkingdownthedemandcurveresultingfromtheaggregationofdealersbidquotes.Similarly,abuyerwithalargeorderwillwalkuptheaggregatesupplycurveresultingfromthedealersaskquotes.Theseaggregatedemand(p.26)


Figure1.7. Dealermarketquotesforvarioustradesizes

andsupplycurvesareshowninfigure1.7.Therefore,asinalimitordermarket,inadealermarketonecanalsodefineaweighted-averagebid-askspreadthatisalsoincreasingintradesize.

Unlikelimitordermarkets,dealermarketsoftenenabletraderstobargainoverpriceandquantity.Forinstance,insteadofsearchingforabetterprice,Seller4inourexamplecouldaskBetaforabetterpricethan324.IfBetaagrees,thenSeller4getswhatiscalledapriceimprovement.Thesearecommoninsomedealermarkets(e.g.,theLSE)andresultintradesatpriceswithinthequotedbid-askspread.Moreover,bydesign,dealermarketsallowdealerstoestablishlong-termrelationshipswiththeirclients.Theymaythenofferdifferentpricestodifferentclients.Forinstance,intheU.S.marketformunicipalbonds(munis),dealersofferbetterpricestoinstitutionalthantoretailinvestors,becauseinstitutionstradelargeramounts,trademorefrequently,andhavegreaterbargainingpower.

Moreover,bargainingmayalsospeedupexecution.Forinstance,aninvestorwithalargeordercanaskthedealertoquotethepriceatwhichheiswillingtotaketheentireorder.Typically,thismaybeworsethanthepricethetraderwouldobtainbysplittingtheorderamongseveraldealersovertime,butitguaranteesimmediateexecutionofthefullorder.Thisisimportanttosometraders,suchasarbitrageurswhomusttakelongandshortpositionssimultaneouslyindifferentmarkets.Thusspeedofexecutionconstitutesanadditionaldimensionofmarketliquidity,sometimesnolessimportantthanthecostoftradingitself(i.e.,thebid-askspread).3

(p.27) Sometimesdealersenterpreferencingarrangementswithbrokers.Inthiscase,abrokercommitstoroutehisorderstoaspecificdealer,andthedealercommitstoexecutethematthebestquotedpriceinthemarketoreventoimprovesystematicallyupontheseprices.Arelatedpracticeispaymentfororderflow:dealersofferingrebatestobrokerswhoroutespecificcategoriesoforders(e.g.,thosebelowagivensize)tothem.

Insomemarkets,suchastheSEAQtradingplatformoftheLSE,dealersundertakespecialmarket-makingobligations.Forinstance,theycommittocontinuousfirmbidandaskpricesforuptoaspecifiedtradesize.Inthiscase,theymustexecuteallincoming


ordersuptothethresholdsizeatthepricequoted.Dealerswithsuchobligationsarecalleddesignatedmarketmakers,althoughoftenthistermreferstoanytypeofdealer.

Bearinmindthatdealersdifferfrombrokers.Brokers(suchasCharlesSchwabintheUnitedStates)onlyexecutebuyorsellordersoffinalinvestors(indifferentlyindealerorlimitordermarkets),buttheydonotactascounterpartiesfortheseorders.Dealers,instead,arethecounterpartiestofinalinvestorsandsotakeinventoryrisk.Somesecuritiesfirms(e.g.,GoldmanSachsorMerrillLynch)offerbothservicestotheirclients,andareaccordinglyknownasbroker-dealers.

Afeaturethatbrokersanddealershaveincommonisthatbothhelpfinalinvestorstocarryouttheirtrades.Forthisreason,brokersanddealersareoftencollectivelyreferredtoasthesellsideofthesecuritiesindustry,whereasfinalinvestors(households,institutionalinvestors,firms,andgovernment)arecalledthebuyside(sincetheybuytradingservicesfromthesellside).4Thisdistinctionisimportantsincethetwosidesoftenhaveopposingviewsonhowtradingshouldbeorganized:asweshallsee,achangeintradingorganizationoftenaffectsthedistributionoftradinggainsbetweeninvestors(thebuyside)andintermediaries(thesellside).

1.2.3HybridMarkets

Manyactualsecuritiesmarketsarehybridscomprisingbothalimitorderplatformandadealersegment,orhavingadesignthatmixesfeaturesofthetwotypesofmarket.

(p.28) Forinstance,theNYSEhasamixofthreedifferenttradingmechanismsthatoperatesimultaneouslyforeachstock:

1.Anopen-outcrymarketwherefloorbrokerstradingonbehalfofotherinvestorsorontheirownaccountbargainbilaterally.52.Adealermarketwithonemarketmaker,thespecialist,foreachstock;thereweresevenspecialistfirmsin2009.3.AnelectronicLOBforeachstockthatallowsinvestorstobypassthespecialistandfloortraders.

CoordinationofthepricesinthesetradingmechanismsisensuredbytheNYSEspriorityrules:whenthespecialistreceivesamarketorder,hemustexecuteitagainstthelimitordersinthebookorelseimproveupontheirprices.Otherhybridmarketsaretraditionalquote-drivenmarketssuchasNasdaqandtheLSEthathaverecentlyaddedalimitordertradingfacilitysothatorderscanberoutedtotheLOBratherthantodealers.

AdifferentformofhybridizationisthatofMTS,aninterdealertradingplatformforEuropeangovernmentbondsinwhichonlysomedealers(theprimarydealers)canpostlimitorders,andtheotherdealerscanonlysubmitmarketorders.Astheplatformusespriceandtimeprioritytoexecutelimitorders,itisalimitordermarket.But,sinceonlyprimarydealerscanpostlimitorders,MTSmayalsobeviewedasadealermarket.Moreover,foreachbondsomeprimarydealersserveasdesignatedmarketmakers;


thatis,theyareobligedtopostfirmbidandaskpricescontinuously,foratleastfivehoursperday,foraminimumquantityandwithamaximumbid-askspreadthatdependsonthebondsmaturityandliquidity.

1.2.4MarketTransparency

Amarketsdegreeoftransparencyisdeterminedbytheamountoftradinginformationavailabletoparticipants.Thisinformationmatterstotraders,asitenablesthemtosharpentheirestimatesofsecuritiesvaluesanddevisebettertradingstrategies.Forinstance,assection1.2.2explained,inadealermarketaninvestorcangenerallygetbettertermsifheobservesalldealersquotes,andcanthussaveonthecostofsearchingforthebestprice.Herewebrieflydiscussthis(p.29) importantdimensionofmarketstructure,leavingamorein-depthanalysistoChapter8.

Transparencyvariesconsiderablyfrommarkettomarket,regardlessofwhethertheyarelimitorderordealermarkets.Indeed,thechoiceoftransparencyisoftenverycontroversialasitaffectshowtradinggainsaredistributedbetweenthesellsideandthebuyside.Intuitively,thedemandforbrokerageservicesanddealersmarketpoweraregreaterinopaquemarkets,sinceitisharderforfinalinvestorstoidentifyalltradingopportunities.Butwhenplatformsdoprovideagooddealofinformationonthetradingprocess,theymaychargesignificantfeesforit.Thus,transparencydependsnotonlyontheavailabilitybutalsothecostofinformation.

Ingeneral,electroniclimitordermarketstendtobeverytransparent.Dataonthebestordersandtheirlimitpricesaredisplayedinrealtime,andastradesareexecuteddirectlybythesystemrealizedtransactionpricesandquantitiescanbepublishedimmediately.Evenhere,however,transparencyisamatterofdegree.Themarketmaydisplayonlythebesttwolimitprices,orthebestfiveortenpricesintheLOB;themarketmayalsoshowthequantitiesandtheidentitiesofthebrokersplacingtheorders,orthetimesatwhichtheordersaresubmitted.6Moreover,eveninsuchamarket,tradersmayhavetheoptionofnotentirelydisclosingtheirtradingintentionsbutmayposthiddenorders,assection1.2.1explains.

Transparencycanalsovaryacrossdealermarkets,dependingonwhetherquotesaredisplayedcentrallythroughasinglescreenandwhethertheyarefirmormerelyindicative.Inthelattercase,customersstillhavetocontacteachdealerdirectlytoverifytheactualpricesatwhichatradewillbeexecuted.Sincedealermarketsarefragmented(dealsbeingstruckwithindividualdealers),itisnoteasytoensurethatthebestquotesarecentrallydisplayedinrealtime.Forexample,somedealersmayquotepricesonlyontheirownproprietarysystems.Itisevenhardertoensurethatcompletedtradesandtheirpricesarepublishedpromptly,asthisrequiresdealerstoreporttheirtradesequallypromptlytoacentralmarketauthority.Inpractice,dealersoftenopposepromptpublicationoftradesortrytocircumventrulesrequiringsuchpublication.

Thelowestdegreeoftransparencyisfoundinso-calleddarkpoolsofliquidity,tradingplatformsthatarenotaccessibletoallcomersbutonlytofinancial(p.30) institutionsthatwishtotradelargeblocksofsecuritiesanonymously.Theseinstitutionsareattracted


todarkpoolspreciselybecausetheycanavoiddisclosingthesizeoftradesandtradersidentities,whichattenuatesanddefersthepricechangecausedbylarge-volumesalesorpurchases.Somedarkpoolsareplatformscreatedbyindependentcompanies;othersareoperatedbybrokerstoallowtheirclientstotradeanonymously;stillothersarespecialsegmentscreatedbypublicexchangestogranttheirclientsthebenefitsofanonymityandopacity.Whendarkpoolsareavailable,theportionoftheorderflowthattheyintermediateisnotvisibletothosewhotradeontheopenmarket,whetheritbealimitorderoradealermarket.Hencetheiropacityalsomakesthemarketmorefragmented:infact,marketopacityandfragmentationarecloselyconnected.

Thedegreeoftransparencyalsovariesbytypeofsecurity.Themarketformajorlistedstocksistraditionallythemosttransparent.IntheUnitedStates,sincethe1975amendmentstotheSecuritiesExchangeAct,consolidatedmarketinformationhasbeenmadeavailable(atacost)throughdesignatedsecuritiesinformationprocessors(SIPs)thataggregatebothquoteinformationandtradereports.Overtheyears,theinformationprovidedhasbeenexpandedconsiderably.Attheotherextremearemarketsinthinlytradedsecuritiessuchasmunicipalbonds,whicharetradedover-the-counter,typicallybybroker-dealerswhofillmostoftheircustomersordersinaprincipalcapacityandtradeamongthemselvesinaninterdealermarkettomanagetheirinventories.Nofirmpricesarequoted,andthepricesatwhichtradesareexecutedaremadeknownonlyforthemostfrequentlytradedissues,andeventhenwithaone-daylag.Inbetweenthesetwoextremes,ofcourse,therearemanyintermediatedegreesoftransparency.

Computerizedtradingfacilitatesdatastorageanddissemination,butitdoesnotnecessarilyentailgreatertransparencyinthetradingprocess.Actually,thephysicalinteractionsoftradersinopen-outcryorfloormarketspermitthetransmissionofahostofinformalcuesthatescapeevenstate-of-the-artelectronicsystems.Iftradersarephysicallypresentinthesameroom,theireverywordandgesturearevisible,yieldinginsightsintotheirtradingstrategiesandtheurgencyoftheirtradingintentions.7Moreover,electroniccommunicationtechnologieshavefacilitatedthedispersaloftradingacrossmultiplevenues,makingithardtopiecetogetheranaccurateviewofoverallmarketconditions.

(p.31) 1.3.DoesMarketStructureMatter?Thetwomainrolesofasecuritiesmarketaretoprovidetradingservicesforinvestorswhowishtoaltertheirportfolios,andtodeterminepricesthatcanguidetheallocationofcapitalbyinvestorsandfirms.Thatis,amarketisefficientifitenablesinvestorstotradequicklyandcheaply(i.e.,ifitisliquid)andifitincorporatesnewinformationquicklyandaccuratelyintoprices.Tradingrulesaffectmarketefficiencyonbothaccounts:indeed,muchofthisbookisdevotedtoexplainingwhythisisso,anddistillingtheempiricalfindingsofavastliterature.Thissectionpreviewsafewempiricalstudiesonhowmarketdesignaffectsliquidityandpricediscovery.

Somestudiescomparetradingcosts(bid-askspreads)inlimitordermarketsanddealermarketsformatchedsamplesofstocks(i.e.,stockswithsimilarcharacteristics).Typicallytheyfindthattradingcostsarehigherindealermarkets,especiallyforsmallorders.For


instance,HuangandStoll(1996)reportthat,byseveralmeasures,tradingcostsforasampleofNasdaqstocksaretwiceashighasforamatchedsampleofNYSEstocks.Onepossibleexplanationisthatconcentratingtradinginasinglemarketplaceimprovesliquidity.Chapter7exploreswhytheconsolidationoftradingcanincreasemarketliquidity.

Changesintradingrulesthatfostercompetitionamongliquidityprovidersalsoresultinamoreliquidmarket.Inearly1997,theSecuritiesandExchangeCommission(SEC)introducedrulesthatexposedNasdaqmarket-makerstocompetitionfromthegeneralpublic.TheLimitOrderDisplayRuleforceddealerstoexecuteordisplayanycustomerslimitordersbetterthantheirown.Thisregulatorychange(togetherwiththequoterulethatrequireddealerstradinginmultiplevenuestomaketheirbestquotesavailabletothepublic)increasedcompetitivepressuresonNasdaqandledtoanimmediateandsubstantialreductioninNasdaqtradingcosts(Barclay,Christie,Harris,Kandel,andSchultz1999).

Changesinmarkettransparencyalsoaffectliquidity.Forinstance,Boehmer,Saar,andLiu(2005)analyzehowmeasuresofmarketliquiditychangedwhentheNYSEstartedreleasinginformationonlimitordersin2002.Theydocumentthatthisincreaseintransparencywasfollowedbyadropinthepriceimpactofmarketordersameasureofilliquidityalternativetotheweightedaveragebid-askspread.Similarly,Edwards,Harris,andPiwowar(2007)examineanincreaseinthetransparencyoftheU.S.corporatebondmarket.SinceJuly2002,thecompletedtransactionpricesofcorporatebondshavebeenshowntomarketparticipants,albeitwithafifteenminutedelay.Sincethischange,bid-askspreadshavedeclinedsignificantly.

Marketstructurealsoaffectsthequalityofpricediscovery.Green,Li,andSchuerhoff(2010)findthatintheUnitedStatesthepricesofTreasuryissues(p.32) reacttomacroeconomicnewsmuchfasterthanthepricesofmunis.AsthemarketforTreasuriesismoreliquidandactive,theauthorssuggestthatthisisresponsibleforthedifferentspeedofpricediscovery.Inturn,munislackofliquiditylargelystemsfromthelackoftransparencyfortheirmarket,asdocumentedbyGreen,Hollifield,andSchuerhoff(2007).Manyotherstudieshaveexploredtheimpactofmarkettransparencyonliquidityandpricediscovery,asthedetailedanalysisinChapter8shows.

Byaffectingliquidityandpricediscovery,marketstructurealsoaffectsthecostofcapital.InChapter9,wewillseethatchangesthatincreaseliquidityraisestockprices,asinvestorsrequirealowerrateofreturntoinvestinmoreliquidstocks.Similarly,Chapter10showshowmoreefficientpricediscoveryisconducivetobetterinvestmentdecisionsbycompanies.

1.4.EvolutionofMarketStructureWehaveseenthattradingplatformsareorganizedinawidevarietyofways.Whydoactualtradingmechanismsdiffersomuch?Thisdependslargelyonwhodecidesthetradingrules,whichistosaythatitdependsonthegovernanceoftradingplatforms.Inthepast,suchgovernancewaspartlytheresultofhistoricalaccident,whichcreated


differentinitialconditionsinthevariouscountries,assection1.4.1explains.Inrecentdecades,however,thegovernanceandorganizationoftradingplatforms,especiallyinequitymarkets,havetendedtoconvergeononebasicmodel.Section1.4.2,arguesthatthisconvergencereflectstheheightenedcompetitioninthesecuritiesindustry,itselftheproductofthecombinedpressureofthreeforces:liberalizationofinternationalcapitalmarkets,securitiesregulationoverhaul,andadvancesininformationandcommunicationtechnologies.Buttechnologicalinnovationhastransformedsecuritytradingoverandaboveitstendencytoreinforcecompetitionbetweentradingplatforms.Section1.4.3describestheenormousimpactoftechnologicalprogressontheautomationofordergeneration,routing,andexecution,andtheincreasinglylivelydebateontheprosandconsofthisevolution.

1.4.1WhoMakestheRules?

Thedesignoftradingrulesistheoutcomeoftheinterplaybetweengovernmentregulationandself-regulationbythetradingplatforms,suchasstockexchangesortradingnetworks.Forinstance,intheUnitedStatesmuchofsecuritiesregulationisdesignedinbroadoutlinebytheSEC,thenimplementedand(p.33) specifiedindetailbytheself-regulatingorganizationsthatgovernthemarkets,suchastheNYSEandNasdaq.

Thescopeofself-regulationandthewayithasbeenusedhavevariedwidelyovertimeandacrosscountries.Fromtheirinception,stockexchangeshavedifferedverysignificantlyingovernanceandorganization.Manyemergedfrominformaltrading.Forexample,whatiswidelyregardedasthefirstmodernexchange,theAmsterdamStockExchange,emergedatthestartoftheseventeenthcentury,whentradinginthetransferablesharesoftheDutchEastIndiaCompanystartedimmediatelyuponissuein1602.TradingwasatfirstconcentratedoutdoorsaroundtheNieuweBrugincentralAmsterdam(infoulweather,thenearbySt.Olofschapelwasused),movingin1611toapurpose-builtcentralizedmerchantsexchange,createdtofacilitatepublictradingnotjustinsharesbutalsoinotherfinancialinstruments,goods,andinsurance(seePetram2011,foradetaileddescriptionofseventeenth-centuryDutchsharetrading).Similarly,theLSEdevelopedfrominformaltradingthattookplacearoundcoffeeshopsinthecity,wherein1698JohnCastingfirstpublishedlistsofstockprices,entitledTheCourseoftheExchangeandOtherThings.Notuntil1801didtheexchangeturnintoanofficial,regulatedstockexchange.TheprecursortotheNYSEwascreatedin1792byagroupofstockbrokerswhosignedtheButtonwoodAgreementunderabuttonwoodtreeonWallStreet.

ManycontinentalEuropeanexchanges,however,werecreatedattheinitiativeofgovernmentauthoritiesandweregenerallyregulatedandmanagedbypublicagencies,suchaslocalchambersofcommerce.TheParisStockExchangewasestablishedbyanorderoftheRoyalCouncilofStatein1724.Bythemiddleofthenineteenthcentury,tradingwasconductedbygovernment-appointedagentsdechangewhoshoutedoutpricesonthefloorandcouldnottradefortheirownaccount:theywerestrictlybrokers,notdealers.Inseveralcases,theexchangeswerefoundedfortheexpresspurposeof


formingamarketspecificallyforstate-issuedbonds,notsharesorevencorporatebonds.ThiswasthecaseoftheViennaStockExchange,foundedin1771underEmpressMariaTheresa,andtheMilanStockExchange,establishedin1808byaNapoleonicdecreeandusedtotradeonlygovernmentbondsforitsfirsthalf-century.

Thus,theconstituenciesthatcreatedstockexchangeswerequitedifferent,andthedifferencesingovernancewerepersistent.Aslateasthe1980s,mostexchangeswerestillgovernedmuchastheyhadbeenattheturnofthetwentiethcentury.Thesedifferencesingovernanceshapedtherulesoftheexchanges,inanillustrationofthemoregeneralprinciplethatthestructureofsecuritiesmarketsisaffectedbytheinterestsoftheircontrollingconstituencies.Dependingontherelativepowerandimportanceofdomesticandforeignintermediaries,(p.34) institutionalinvestors,andissuersintheshareownershipstructure,differentexchangespursuedifferentpolicies.Forinstance,anexchangethatisstrictlycontrolledbyacartelofdomesticintermediarieswillbemoreinclinedtoimpederemoteaccessforforeigninvestors,andmoregenerallywillbereluctanttorevisethetradingsystemtothedetrimentoflocalintermediaries,asinthecaseoftheLSEsprotractedresistancetotheintroductionofanLOBandtheNYSEmembersoppositiontoendingfloortrading.

Moregenerally,theinterestsofintermediariesoftenconflictwiththoseofissuersandinvestors:theformertendtofavortradingrulesthatprotecttheirrentsattheexpenseofthelatter.Chapters7and8showthatsuchconflictsareacommonfeatureinpolicydebatesaboutmarketfragmentationandtransparency.

Bythesametoken,changesintheinstitutionalformandgovernanceofexchangescanimpactthestructureoftheirmarkets.Suchchangeshavebeenfrequentinrecentyears,asmostexchangeshavebeentransformedfromessentiallyprivateclubs(suchastheLSE)orsemi-publicentities(suchastheParisBourse)intopubliclyheldcorporations,inwhichthelargeststakesareusuallyheldbymajorfinancialintermediariessuchasbanks,hedgefunds,andbrokeragehouses.TheLSE,DeutscheBrse,Euronext,Nasdaq,HongKongStockExchange,andTorontoStockExchangeallwentpublicin2000,whileseveralotherexchangesincontinentalEuropehaddonesointhelate1990s.TheNYSEfollowedsuitin2006.

1.4.2CompetitionbetweenExchanges

Asjustnoted,fromsharplydivergentinitialconditions,stockexchangeshaveconvergedonasimilarstatusaspubliclylistedcompanies,througheithertheprivatizationofthegovernment-controlledexchangesorthedemutualizationofthoseownedandcontrolledbygroupsofintermediaries.Asfor-profitfirms,theirchoicesregardingmarketstructurearenaturallymoreandmoregearedtomaximizingshareholdersprofits.8

Tounderstandhowthisprofitorientationalteredtheirchoices,notethattradingrevenuesaccountonlyforafractionofthetotalprofitsofanexchange.Twootherimportantsourcesofrevenuearelistingfees(paidbyissuingfirms(p.35)


Table1.1BreakdownofStockExchangeRevenues(Percent)SourceofRevenue/Area Americas Europe AsiaListingfees 25 7 12Tradingfees 34 42 47Otherservices 39 45 35Source:AnnualReportoftheWorldFederationofExchanges,2005.Otherservicescomprisethesaleofmarketdata,tradingtechnologies,andclearingandsettlementservices.

wholisttheirsharesontheexchange),andthesaleofmarketdata,suchasreal-timequotes.Forinstance,in2003thesaleofmarketdatagenerated$386millionforU.S.equitymarkets,whilethecostoftheirdisseminationwasjust$38million.ThesaleofmarketdataisimportantforEuropeanexchangesaswell:in2005thesaleofmarketinformationaccountedfor33percentoftheLSEsannualrevenueand10percentofEuronexts.Moreover,insomecases(suchasDeutscheBrse),exchangesalsosellclearingandsettlementservices.Table1.1reportsthebreakdownofrevenuesamongthevariousservicessoldbystockexchangesindifferentgeographicalareas(therevenuefromthesaleofdataisincludedinotherservices).

Thevariousservicessoldbyexchangesarecomplements.Hence,decisionsonmarketstructurearemadenotonlyconsideringtheimpactontradingvolumebutalsowithaneyetotheireffectonlistinganddatasalerevenues.9Forinstance,anexchangemaybewillingtochargelowlistingfeesinordertoattractmanyissuersandsoearnlargetradingrevenues.Oronethatoperatesitsownclearingandsettlementsystemmaychargelowtradingfeesinordertocapturetradingflowsandchargelargeclearingandsettlementfees.

Inrecentyears,competitionhasbeenincreasinginallofthesebusinesslines.Thechangeingovernancehasbeendrivenlargelybythisevolution:theexchangesbecamepubliclylistedcompaniessoastogaintheflexibilityneededtocompetewithalternativevenues,bothathomeandabroad.Theintensificationofcompetitionbetweentradingplatformsistheresultofthreeforces:

(i)Theremovalofbarrierstointernationalcapitalflowshasincreasedfirmspropensityforinitialpublicofferings(IPOs)onforeignmarketsorcross-listingoftheirshares,andpromptedincreased(p.36) cross-bordertradingbyinvestors.Forinstance,investorscancurrentlytrademanyFrenchblue-chipstocksnotonlyonEuronextParisbutalsoonforeignmarkets:multilateraltradingfacilities(MTFs),suchasChi-X,orexchangeswherethestocksarecross-listed(suchasDeutscheBrseandtheLSE).10Inthisenvironment,stockexchangesincreasinglycompeteforlistingsandcross-listings.OnesignofthisistherecentdeclineintheshareofglobalIPOstakingplaceintheUnitedStates(seeZingales,2007).


(ii)Changesinthesecuritiesmarketregulationshavealsoplayedarole.IntheUnitedStates,theincreasedfragmentationresultingfromtheproliferationofelectroniccommunicationnetworks(ECNs)providedmajorimpetusforcreatinganewregulatoryframework,RegulationNationalMarketSystem(RegNMS),in2005.AmajorgoalofRegNMSistoorganizeandfacilitatecompetitionbetweentradingplatforms.Forinstance,itsorderprotectionrulesobligetradingplatformstore-routeincomingmarketorderstotheplatformthatpoststhebestpriceatthemomenttheorderisreceived.Clearly,thisruleheightensthecompetitionfororderflowamongplatforms,andamongtheliquiditysuppliersthatoperateoneachplatform.Chapter6analyzestheeffectsofthisruleingreaterdetail.InEurope,theMarketsinFinancialInstrumentsDirective(MiFID),whichwentintoeffectin2007,alsoincreasedcompetitionfororderflowbetweentradingplatforms.Inparticular,itabolishedtheconcentrationrulebywhichmemberstatescouldobligeinvestorstoroutetheirorderstothenationalmarket.Asaconsequence,itspurredthecreationofmanynewplatforms,suchasChi-X(launchedin2007),ProjectTurquoise,NASDAQOMXEurope,BatsEurope(alllaunchedin2008)andNYSEArcaEurope(launchedin2009).AlltheseplatformsoperateEurope-wideelectronicLOBs.(iii)Technologicaladvancesininformationandcommunicationtechnologiesforsecuritiestradinghavegreatlyfacilitatedentryintothemarketfortheprovisionoftradingservices.ThecostofsettingupanelectronicplatformsuchasaLOBisnowextremelylow,andmanyplatformshavecomeintobeingsincetheturnofthe1990s,knownasECNsorAlternativeTradingSystems(ATSs)intheUnitedStates,andMTFsinEurope.SuchplatformsincludeIsland(subsequently(p.37)renamedINETandboughtbyNasdaq),Archipelago(nowpartofNYSE),InstinetandBATS.Moreover,withsmartorder-routingtechnologies(SORs)brokerscaneasilysplitordersacrossmarketstogetthebestprices.Suchtechnologieshaveloweredthecostofsearchingforthebestpriceacrosstradingplatformsandsomadeiteasierforexchangestoattracttradingbusinessbyofferingnarrowbid-askspreadsandlowfees.

Facedwithsuchcompetition(whetheractualormerelypotential),theincumbentmarketshavereactedbymergingtoachieveeconomiesofscaleandcapitalizeonliquidityexternalities(seeChapter7).In2000theParisBoursemergedwiththeAmsterdamStockExchangeandtheBrusselsStockExchange(subsequentlyjoinedbytheLisbonStockExchange),toformEuronext.In2007,EuronextinturnmergedwiththeNYSE,enablingtheseexchangestocutoverheadcostsandbuildupvolumeandliquidity.

Competitionhasalsoforcedtradingplatformstoslashfeesandpasssomeofthecostsavingsfrommergersontousers.Forinstance,in2003,theLSEannouncedthatitwouldintroduceatradingplatformforDutchstocks,EuroSETS.ThiswasspurredbytheDutchbrokeragecommunityasawaytolowerEuronexttradingfees,andinfactEuronextslasheditsfeesby50percentinearly2004(FoucaultandMenkveld2008).

Finally,competitionpromptedtheincumbentstooverhaultradingsystems.Forinstance,


untilrecentlytheNYSEstillreliedheavilyonaseriouslyoutdatedfloor-basedsystem,totallyunabletomatchtheexecutionspeedofelectronictrading.Thattradingsystemgaveaninformationaladvantagetomemberswithaseatonthefloor;theythushadavestedinterestinretainingfloortrading.ButascompetitionfromECNserodedtheNYSEsmarketshare,thepositionbecameuntenable.In2006,theNYSEacquiredarivalelectronicordermarket,Archipelago,renameditNYSEArca,andmadeitthecoreofitstradingsystem.By2009,Arcawasprocessingfour-fifthsoftheNYSEstotaltradingvolume.Floortradingisessentiallybeingphasedout.

1.4.3Automation

Aswehaveseen,technologyhasintensifiedcompetitionbetweentradingplatforms.Buttheeffectsofinformationprocessingandcommunicationtechnologyonsecuritiestradinggowellbeyondthis:overthelasthalf-centurytechnologyhascompletelyreshapedthetradingprocess.Inthepast,securitieswereboughtandsoldontradingfloorswherebrokerswereinchargeofmatchingthebuyandsellorderstheyreceivedfromtheirclients.Butsecuritiesexchangesprogressivelyreplacedorcomplementedtheirtradingfloorswithcomputerizedtrading(p.38) systems.Today,mostexchangesuseelectronictrading(mostlyLOBs),andordersarenowroutedviahighspeedfiberopticlinestocomputersthatmatchthemaccordingtopredeterminedtradingrules.Forinstance,Jain(2005)findsthat101of120countriesexaminedhaveelectronictrading,and85nolongerhavefloortrading.

FortheNYSE,thisevolutionbeganwiththeDOTsystemin1976,whichallowedelectronicsubmissionofmarketordersofuptoonehundredshares.Uponreachingthetradingfloor,theelectronicDOTordersweremanuallyexecutedbythespecialist.ButtheNYSEdidnotbecomeafullyelectronicexchangeuntil2006withtheintroductionoftheNYSEHybridsystem.Bycontrast,suchexchangesastheTorontoStockExchangeandtheParisBoursewentovertofullyelectronicLOBmarketsquiteearly(1977and1986,respectively).Theirtradingsystemsweretheblueprintforothers.

Thisevolutionhasanumberofsignificantconsequences.First,itincreasesthenumberofquotesandtheamountoftradedatathatexchangescanmakepublicandthespeedatwhichtheydoso.Infact,tradingplatformscompeteinthespeedofdisclosureofinformationontradesandquoteupdates.Thetimethatelapsesbetween,say,aquoteupdateandthereleaseofthisinformationtomarketparticipantscalledlatencyisbynowmeasuredinmilliseconds.

Second,professionaltraders(proprietarytradingdesksorhedgefunds)haveexploitedtheautomatedtradingprocesstodevelopelectronictradingstrategies,apracticeoftenreferredtoasalgorithmictradingorhigh-frequencytrading.11Thesestrategiesrelyonsophisticatedcomputerprogramstogenerate,route,andexecuteorders,andtheirsuccessoftendependsonextremelyrapidtransmissionoforders(andoftheircancellations)tothetradingplatformsandreceptionoftimelydatafromthem.12Thesediversestrategiescanbeclassifiedinfourbroadtypes:(i)passivemarketmaking,(ii)arbitrage,(iii)directionaltrading,and(iv)ordersplitting(seeSEC2010).Algorithmic


tradesnowaccountforalargefractionoftradingvolume,atleastinequitiesmarkets.13

(p.39) Passivemarketmakingdenotesthesubmissionofnon-marketablebuyandselllimitorders.Theseordersaretraditionallyviewedasprovidingliquiditytomarketparticipants,verymuchasdealersdo.Firmsthatdothis(suchasGETCO,Optiver,ATD,etc.)arethereforefunctionallycomparabletomarketmakers;theyattempttocloseouteachtradingdaywithnoinventoryexposure.However,insomerespectstheydifferfromtraditionalmarketmakers:intheirhighlyautomatedroutinesforthesubmissionandrevisionoftheirquotes(basedoninventoryexposure,pricesignalsfromothermarkets,etc.);andintheirnottradingdirectlywithclientsbutratheroperatingonlyonLOBmarkets,competingwithotherlimitordertraders.

Computerizedtradingalsoenablestraderstoexploitpricediscrepanciesbetweenrelatedsecuritiesimmediately.Anobviousexampleisthecaseofastocktradedontwoplatforms,saytheFrenchstockAlcatel,whichtradesonbothChi-XandNYSE-Euronext.IfthebidpriceforAlcatelonChi-XexceedstheaskpriceonNYSE-Euronext,onecanmakeaprofitbybuyingitonNYSE-EuronextandsellingitonChi-X.Speedisoftheessence,though,astheprofitwillbelockedinonlyifthetwotransactionsarevirtuallysimultaneous.Suchstraightforwardarbitrageopportunitiesarerareandfleeting,preciselybecauseparticipantstakeadvantageoftheminasplitsecond.Moregenerally,algorithmictradingcanenableonetodetectandbenefitfromtransientdeviationsbetweenthepricesofrelatedsecurities(e.g.,derivativesandtheirunderlyingsecuritiesorexchangeratesthatshouldbetiedbytriangulararbitrage)beforeothermarketparticipants.

Directionaltradersexploitinformationnotyetreflectedinprices.Theirinformationaladvantagecanbeveryshort-lived.Forinstance,consideranewsreleasethatleadsinvestorstomarkupthevalueofafirm.Investorswhocanplacebuymarketordersalmostinstantaneouslycanprofitbypickingoffstaleselllimitorderswhosepricesdonotyetreflectthenewvalue.14Again,speedisoftheessence,sinceinvestorswhotradeonsuchinformationcanmakeaprofitonlybymovingbeforetradersontheothersidecanceltheirlimitorders.Directionaltradersalsobenefitfromtechnologiesthatassisttheminsearchingandprocessinginformation(e.g.,scanningtheInternetforcertainkeywordsaboutstocks).

Lastly,algorithmictradingisalsousedbytraderswhoneedtoaccumulateorliquidatelargepositions.Theyoftenusesmartorder-routingtechnologiesto(p.40) breakuplargeordersoptimallyinspace(betweentradingplatforms)ortime,soastominimizetotaltradingcosts.Smartroutersveryquicklyidentifywherethebestquotesarepostedandalsooptimizetheplacementoftheorderincontinuoustime,dependingonchangingmarketconditions(asdescribedbyBertsimas,andLo1998orHuberman,andStanzl2007).

Thisevolutionhastriggeredhotdebateontheimpactofalgorithmictradingonliquidity,pricediscovery,volatility,andrisk.Ontheonehand,automationcanreducethecostsbornebyliquidityproviders(seeChapter3).Forinstance,dealersabilitytoquickly


refreshtheirquotesonthebasisofnewinformationreducestheirexposuretotheriskofbeingpickedoffbyinformedtraders.Automationalsohelpsthemtomanageinventoryriskby,say,takingapositioninonemarketandhedgingitalmostinstantaneouslyinanother.Thushigh-frequencymarketmakersmayenhancemarketliquidity.Hendershott,Jones,andMenkveld(2011)provideempiricalsupportforthisconjecture,showingthattheriseofalgorithmictradingontheNYSEcoincidedwithanarrowingofeffectivebid-askspreads,mainlybecausealgorithmictradingseemstoreducetheadverseselectioncomponentofthespread(thatis,thecompensationrequiredbydealersfortheriskoftradingwithbetterinformedinvestors;seeChapter3).Moreover,computerizedtradingshouldattenuatepriceinefficienciesandimprovepricediscovery,sinceithelpsdealersadjustquotesmorequicklyandmakesarbitrageursspeedierincorrectingmispricing.HendershottandRiordan(2009)accordinglyfindthatalgorithmictradingincorporatesmoreinformationintopricesthanhumantradingandthatthequotespostedbyalgorithmictradershavemoreinformationcontent.

Ontheotherhand,algorithmictradinghaspromptedconcerns.First,itmightbenothingbutawayforthealgorithmictraderstomakeprofitsattheexpenseofslowertraders,includinglong-termretailandinstitutionalinvestors(justasinformedinvestorsprofitattheexpenseofthelessinformed;seeChapter3).Inthiscase,thetechnologicalinvestmentinthisactivitywouldbesociallyuseless,consumingresourceswithoutincreasingoverallgainsfromtrade.ThisviewwasvividlyexpressedbytheNobelprizewinnerPaulKrugmanin2009:

High-frequencytradingprobablydegradesthestockmarketsfunction,becauseitsakindoftaxoninvestorswholackaccesstothosesuperfastcomputerswhichmeansthatthemoneyGoldmanspendsonthosecomputershasanegativeeffectonnationalwealth.AsthegreatStanfordeconomistKennethArrowputitin1973,speculationbasedonprivateinformationimposesadoublesocialloss:itusesupresourcesandunderminesmarkets.15

(p.41) Asecondconcernistheimpactofalgorithmictradingonvolatilityandsystemicrisk.Thereareseveralgroundsforthisworry.Recentyearshavewitnessedanumberoffatfingermistakescasesinwhichatradermistakenlyexecutedamuchlargertradethanintended.Also,thetradingstrategiesofalgorithmictraderstendtoresembleoneanother,soalgorithmictradescanbehighlycorrelated.Simultaneousmovementsintoandoutofspecificsecuritiesmayleadtosharpvariationsinliquiditysupplyanddemand,increasingpricevolatility.16Finally,asalgorithmictraderscancarryinformationswiftlyfromoneassetclasstoanother,theyarelikelytoincreaseco-variationinstockreturnsandliquidity.

Lastly,ultra-fasttradingincreasesthepossibilityoftechnologicalbugswithdramaticconsequences.Peaksofalgorithmictradingactivityinreactiontothesameeventmaystrainthecapacityoftradingsystemsandcauseseveremarketdisruptions.Forinstance,algorithmictradingisoftenassociatedwithhugenumbersofordersubmissionsthataresubsequentlycancelled.Aflurryofordercancellationsonaplatformcandelaythespeedatwhichitreportstradeinformation.Inturn,thisdelaydistortstheinformationsentto


otherparticipantsandmaycreatearbitrageopportunitiesforinvestorswhoareawareofthedelay.17Thissuggeststhatsomemarketparticipantsmaydeliberatelyswampplatformswithmessages(quotesandcancellations)solelyinordertomanipulatethetape(thequoteandtradeinformationreportedtootherparticipants),astratagemknownasquotestuffing.ThepotentiallydestabilizingroleofalgorithmictradinghasrecentlybeenunderthespotlightinconnectionwiththeFlashCrashonU.S.equitiesmarketsinMay2010(seebox1.2).

OnMay6,2010,theDowJonesIndustrialAverageexperienceditssecond-largestintra-daypointswingeverrecorded,fallingby9percentinamatterofminutesbeforereboundingby5percentbytheendoftheday.Thestocksmakinguptheindexlostabout$1trillioninmarketvalueinthehalfhourbetween2:30p.m.and3:00p.m.,beforebouncingbacktoalevelnottoofarfromtheinitiallevel.Someindividualstocksunderwentevenmoredramaticswings.Forinstance,Accenturesharesfellbyover99percent,from$40to$0.01,whileSothebyssharesrosethree-thousand-fold,from$34to$99,999.99.Whatwasthecauseoftheflashcrash?Specifically,canweconsideritaninstanceofthedestabilizingroleofalgorithmictrading?Thisquestionisstillunderdebate;thefullchainofeventsisnotyetwellunderstood.

AjointreportbytheCommodityFuturesTradingCommission(CFTC)andtheSEC(CFTC-SEC2010)foundthatthecrashwastriggeredbyasingleverylargesellorderintheE-miniS&P500index:alargemutualfundsoldanunusuallylargenumberoffutures;firsttheorderexhaustedavailablebuyers,andthenitprecipitatedadditionalsalesbyhigh

market liquidity

Documents