©r. schwartz equity markets: trading and structure slide 1 topic 7

©R. Schwartz Equity Markets: Trading and Structure

Topic 7


We have thus far considered

• The plain vanilla, order driven market

• A simple limit order book

• Continuous trading and call auction facilities

The Plain Vanilla Order Drive Market


Is Trading Really This Simple?


Electronic Order Book Systems Work Well For

• Retail order flow

• Liquid stocks

• Non-stressful conditions

But A Plain VanillaElectronic Trading System

Cannot do it All


More Structure is Needed!


• Emergence of the Modern Markets• Intermediation on the New York Stock Exchange• Intermediation at NASDAQ

The Need for Intermediation

Read on Your OwnText Pages 217 - 238


The Ecology of an Order Driven Market Can Break Down

• Free riding

• Small and mid-cap stocks

• Stressful conditions


• A bear market

• Advent of news

• Derivatives expirations

• Momentum trading

• Daily openings

• Arrival of a 300,000 share order

Stressful Conditions


Market Maker Operations


TraderEx Dealer Screen


Market Maker Services

• Immediacy

• Supplemental liquidity

• Price discovery

• Animation

• Price improvement (pages 258-260)


Immediacy

• Market maker practices are designed to facilitate the rapid execution of customer orders

• However, orders are commonly traded patiently (i.e., without immediacy)

– Upstairs negotiation of large block trades

– Breaking up large orders for submission over time

– Limit orders


Market Maker Revenues

• Spread

• Trading the Order Flow

• Commissions


Market Maker Costs

• Inventory cost: Cost of carrying unbalanced inventory

• Information cost: Cost of trading with better informed participant


What Makes a Market Maker Successful?

• Inventory control

• Trading the order flow carefully

• Ability to hide/disguise large positions

• Knowledge of customers (source of the order flow) is also important in practice

• Receiving a large percentage of the order flow


Quotes and Inventory Positions


Inventory Control in TraderEx

• If P* jumps above your offer, your customers will, on net, be buyers and your inventory will fall

• As your inventory falls, you raise your bid and offer

• The higher bid attracts sellers and the higher offer discourages buyers

• What happens to your inventory if your bid is raised above P*?

Your inventory is controlled by adjusting your bid and offer relative to the unobserved P*


Transparency

"Shares sold to a market maker are still for sale”

You do not want your inventory revealed by a trade publication

As a Market Maker, How Transparent Do You Want the Market To Be?

After you acquire a large inventory in the process of servicing a customer, you must work off that position


• Knowing their customers

• Offering an array of services

• Developing customer relationships; this results in

Preferencing

Quote matching

A market spread that is greater than it would be in an order-driven environment

How Market Makers Compete


Market Maker Preferencing

What effect would preferencing have on

• The volume of orders you receive?

• Your inventory control?

• Your profitability?

Under which regime would you prefer to operate:

• Preferencing, or

• Strict price and time priorities?


Block Trading


The Challenge

How do you handle an order to buy half a million shares of a stock that, on average,

trades 300,000 shares a day?

• Dealer capital

• Shop the order

• Slice and dice the order and submit the tranches to an electronic platform

• Call auction

• Block trading facility


Costs

• Bid-ask spread

• Market impact

• Opportunity cost

• Implementation short fall

• Losses due to bad market timing


Performance Measure

Difficult to measure performance

• Need a good benchmark

• Do not make assessments on a trade-by-trade basis

• TraderEx point score


Electronic Intermediaries

Dark pools

• Crossing network (e.g., Posit, Matchpoint)

• Negotiation venue (e.g., Liquidnet)

• Order matching system (e.g., Pipeline)


Dark Pools

Free Riding On Price Discovery While OfferingQuantity Discovery

• Institutions keep their orders hidden to control their transaction costs

• How do they find each other and trade?

• The problem is called Quantity Discovery


Shortcomings of Dark Pools

• Lack transparency

• Low crossing rates

• Exclusivity

• Sheer numbers


TraderEx Block Trading

Block Board


TraderEx Block Trading

• Institutional Orders

• Pipeline Order Flow is separated from the Order Book

• Price of order execution is determined from the Market (Order Book)

• Minimum Order Size Constraints


• Passive Order – Bid price is below the bid/ask spread midpoint

• Active Order – Bid price is above the midpoint

• Vice versa for ask price

• Market / Limit

• Reward for being Aggressive

TraderEx Pipeline Orders and Execution


TraderEx Pipeline Colors and Features

• Orange : There is a pipeline order for that stock

• Orange with Red : You have placed a sell order

• Orange with Green : You have placed a buy order

• Yellow with Green : You have placed an aggressive buy order and there is a passive sell order

• Yellow with Red : You have placed an aggressive sell order and there is a passive buy order


• Take (Hit) the Passive Offer (Bid)

• Bid/Ask spread protection

TraderEx Pipeline

Take Bid

©r. schwartz equity markets: trading and structure slide 1 topic 7

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