Introduction and Market Microstructure Data

Prof. Ingrid M. Werner

Spring 2004

What is market microstructure?• Traditional asset pricing aims to understand what should

be the price of a security. It does not, however, address how prices adjust to reflect news nor does it explain how investors’ subjective assessment of a security “get into” the price.

• In practice, news and investors’ valuations are incorporated into security prices through trading.

• This means that the specific trading rules, and the strategies traders develop in response to these rules, will affect how asset prices change over time in response to new information.

What is Market Microstructure?

• Maureen O’Hara:“Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.”

• It is one of the most rapidly growing areas in Finance.

• It has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.

Vignette WFA Sunriver, OR, 1996• Distinguished speaker Prof. Joseph Williams UBC

“The problem with Finance is that we have lost touch with the business world and the needs of those who are supposed to apply our theories.”

• Comment by Prof. Maureen O’Hara, Cornell

“He obviously does not follow the field of market microstructure…”

• Market microstructure is probably the area in Finance with the closest ties to practice.

• Conferences draw a steady crowd of practitioners, regulators, lawyers, and computer scientist who pay “exorbitant” conference fees to hear academics present thei research findings!!!

Cheerleaders• Market centers have made transactions data available to

researchers– Equities:

• NYSE, Nasdaq, Regionals, Island (INET)• Paris Bourse, London Stock Exchange, Toronto Stock Exchange,

Tokyo Stock Exchange, Hong Kong Stock Exchange, Korea Stock Exchange, …

– Derivatives:• CBOE, ISE, CME, etc.

– Bonds:• GovPX

– Exchange Rates:• Ohlsen Associates, Reuters

Cheerleaders

• Market centers have also provided generous research support.– NYSE Visiting Academic Fellow

• Paul Bennett

– NYSE Day on the Floor Program

– Nasdaq Visiting Research Economists• Frank Hatheway and Tim McCormick

– Tailored datasets

– Proprietary data

– Commissioned studies

– Conferences…

Regulators actually listen!

• Believe it or not, this is a field where the regulators actually listen to the advise of academics!– Manning Rules (1994, 1995)

– Concept Release (1999, Richard Lindsey)

– Regulation ATS (1999)

– Decimalization (2000-2001, Larry Harris)

– Rule 11Ac1-5, Rule 11Ac1-6 (2001, Mark Ready)

– Regulation NMS (2004, Larry Harris)

– Public Comment

– Round table discussions

Why do they care?• Data guided by theory, Theory guided by data• Efficiency – welfare issues

– Is insider trading bad?• Market design issues

– Agency auction market– Dealer market– Electronic limit order books

• Market performance issues– Transaction costs– Shock absorption/resiliency– Trading halts

• Competition for order flow• Industrial organization

What is in it for me?

• Given the amount of research in the area, it still surprises me how limited our knowledge is of different market structures.

• This is good news!!!• There is plenty of room for more research!!!• This course will cover only the basics.• I will try to point you in the direction of fruitful

areas for research as we go along.

Who am I?

• Instructor: Prof. Ingrid M. Werner– At OSU since 1998

– Prior to that, at Stanford Business School (1990-1998)

– PhD economics from University of Rochester (1990) and MBA from Stockholm School of Economics (1984)

– Visited NYSE 1997

– Visited Nasdaq 2001-2002

Course Topics

• Introduction and market microstructure data.• Market making and inventory control• Asymmetric information and strategic trading• Block trades and institutional trading costs• Limit order books and order submission strategies• Estimating structural microstructure models (PIN),

modeling irregularly spaced data (ACD), linking microstructure to asset pricing, event studies, etc.

Empirical Projects

• Project I– Inventory control– Data from the London Stock Exchange

• Project II– Intraday patterns and trading costs– Data from the NYSE and Nasdaq (TAQ)

• Project III– Order submission strategies– Data from the Paris Bourse

Major trading issues

• Liquidity • Transaction Costs• Informative Prices• Volatility• Trading Profits

Forces affecting the structure of markets

• Demand for trading– Liquidity trading

– Information trading

– Noise trading (Black (1991))

• Order processing costs– Information system

– Order routing systems (e.g., SuperDOT)

– Order execution system (e.g., SuperMontage)

– Clearing and Settlement

Forces affecting the structure of markets

• Technology and automated trading– Resistance/vested interests (e.g., NYSE floor

community!)

– Block traders

• Risk bearing– Inventory risk

– Payments risk

• Institutionalization– 50% of volume is institutional traders

Forces affecting the structure of markets

• Free trading options– Stale limit orders– Stale quotes

• Information trading– Liquidity traders lose– Informed traders need to be compensated for research

• Anonymity, Reputation, Transparency– Disclosure of trades and quotes– Delayed disclosure– Upstairs facilitated trade– Reputation through repeated trading

Players

Two sides of the trading industry• People and institutions who use market services

are on the buy-side. • Those who provide market services are on the sell-

side. • These sides have nothing to do with whether you

are a buyer or seller of a specific security.

Buy-side players - Investors

• Individuals • Corporate pension

fund sponsors• Charitable trusts• Legal trusts• Endowments

=> Stocks and Bonds

• Investment managers• Corporate investment

funds• Insurance reserve

funds• Governmental funds

Buy-side players – Borrowers and Hedgers

• Homeoweners

• Students

• Corporations

=> Mortgages, Bonds, Notes

• Farmers

• Manufacturers

• Miners

• Shippers

• Financial Institutions

=> Forwards, Futures, Swaps, and Options

Sell-side players

• Dealers trade for their own accounts.– Day Traders– Scalpers– “Locals”

• Brokers trade for other people’s accounts. – Retail and institutional– Full-service and discount

• Broker-dealers do both.– Specialists– Wire houses

Sell-side trade facilitators

• Exchanges provide systems that help traders arrange their trades. – Note that exchanges and brokers often compete with each

other.

• Clearing firms clear and settle trades– E.g., Bear Sterns.

• Clearing houses help settle trades and guarantee that traders will perform.

• Depositories and custodians hold securities.

A typical set of relationships• A sponsor owns funds.• An investment manager makes portfolio decisions.• A broker implements trade decisions. • A dealer supplies liquidity. • A clearing house guarantees the trade.• A depository holds the security.• Consultants advise everyone.

The Market Centers

US primary listing market• New York Stock Exchange (N)• American Stock Exchange (A)• Nasdaq (Q)• Over-the-Counter (OTC)

– Nasdaq small cap (S)

– OTCBB (U)

– Pink Sheets

US regional exchanges• Pacific Exchange / Archipelago (P)• Chicago (formerly Midwestern)

Stock Exchange (M) • Boston Stock Exchange (B)• Philadelphia Stock Exchange (X)• Cincinnati Stock Exchange (C)

Third markets• OTC Dealers (Madoff, Knight/Trimark) (T)• Jefferies, Jones & Co, Cantor Fitzgerald• ECN’s (Proprietary trading systems)

– Instinet– Island– Archipelago– Posit– The Crossing Network– Bloomberg B-Trade– Liquidnet– Harborside

The market for Nasdaq stocks today

broker-dealers

public investorsSEC

non U.S.markets

CHX

direct access

Posit

CrossingNetwork

Liquidnet

U.S. markets

Island

ARCAInstinet

NASDAQSuperMontage

10 ECNs

Amex

CSEPHLX

Merging

NASD broker dealers

Source: Goldman Sachs, Trading & Market Structure Analysis

Volume distribution – Nasdaq stocks

Distributionby Print Venue

Nasdaq SM

17%

ARCA25%

CINCI21%

ADF6%

Nasdaq Other30%

CHICAGO1%

Distribution by Execution Venue

Nasdaq SM17%

ARCA25%

Liquidnet0.1%

Instinet & Island23%

Posit0.5%

Chicago1%

Other33.4%

October 2003

Share volume Single-counted Internal matches only All hours Excluding ETFs

Mostly broker-dealer upstairs trades

But also small activity on:

• Brut (also in SM)

• NexTrade (also in SM)

• MarketXT (also in SM)

• Attain (also in SM)

• TradeBook (also in SM)

• Other ATSs

2 to 5 percent?

Source: Goldman Sachs, Trading & Market Structure Analysis

The market for NYSE stocks today

broker-dealerspublic investors

SEC

U.S. markets

direct access

non U.S.markets

Instinet

10 ECNs NASD broker dealers

ARC

NYSE CSE

PHLX

CHX

BSE

ITS

KnightMadoff

Liquidnet

Millennium

HarborSide

Posit

CrossingNetwork

Source: Goldman Sachs, Trading & Market Structure Analysis

Volume distribution - NYSE stocks

Source: Goldman Sachs Trading & Market Structure Analysis

Other exchanges

3%

Nasdaq InterMarket

15%

NYSE77%

ARCA1%

Chicago4%

2%

1%

12%

0%

Broker-dealers Posit Other ECNsand ATSs

Seeing through Nasdaq InterMarket

Single-counted, share volume

Internal matches only All hours Excluding ETFs

October 2003

Major international stock markets• Europe;

– London Stock Exchange (LSE)– EuroNext (Paris/Netherlands/Belgium)– Deutsche Borse (DB)– Milan Stock Exchange– Swiss Stock Exchange (also Virt-X)– Stockholm/Copenhagen/Helsinki/Oslo (OM)

• Asia:– Tokyo Stock Exchange (TSE)– Taiwan Stock Exchange– Korean Stock Exchange– Australian Stock Exchange (ASX)– Hong Kong Stock Exchange

• Toronto Stock Exchange (TSX)

US bond markets• Corporate and government bonds trade OTC in

wire houses.– Inter-dealer brokers often organize markets.

– E.g., Cantor Fitzgerald (eSpeed)

• NYSE- and AMEX-listed corporate bond markets are very small.

US Derivatives markets• US Equity options

– CBOE

– Amex

– P-Coast

– Philly

– ISE

– BOX

• US Futures– CME

– CBOT

– NYMEX

– NYBOT

– KCBOT

– MGE

– …

The regulators• Securities and Exchange Commission (SEC)

– Securities markets, equity options markets, and cash-settled equity index options markets

• Commodity Futures Trading Commission (CFTC)– Commodity spot, forward, and futures markets

• The SEC and the CFTC write regulations to interpret and implement the laws that fall into their jurisdiction

• They also collect and disseminate information• Additional regulators include: the Federal Reserve Board

(Reg. T margins), state-specific SECs, SROs, FASB, AIMR, IOSCO, WFE, and ICSA…

A Primer on Orders

What are orders?

• Orders are instructions that traders give to the brokers and exchanges which arrange their trades.– Instrument (or instruments) to trade.– How much to trade.– Whether to buy or sell.– Conditions

• Limit price• Duration• Partial or fill-or-kill• Where to present the order• How to search for other side• Desired counterparts…

Who uses orders?

• Traders that either do not have direct access to the markets, or do not have the time to monitor the markets use orders.– Have to anticipate what is going to happen.– Have to clearly delineate contingencies.– At a disadvantage vis-à-vis professional traders.

• Risk of misunderstandings• Conflicts of interest• Speed of reaction to changing market conditions• Cancellations can be time consuming• Access to order flow information

What are bids and offers (asks)?• Dealers have an obligation to continuously quote bids and offers, and

the associated sizes (number of shares), when they are registered market markers for the stock.

• Their quotes also have to be firm during regular market hours.• Public orders with a price limit can also become the market bid or offer

if they are at a better price than those currently quoted by a registered market maker.

• The market’s best bid and offer constitute the inside market, the best bid/ask, or the BBO. The best bid and offer across all markets trading an instrument is called the NBBO.

• The difference between the best offer and the best bid is the bid/ask spread, or the inside spread (touch, fourchette, vigorish…)

• Orders supply liquidity if they give other traders the opportunity to trade.

• Orders demand liquidity (immediacy) if they take advantage of the liquidity supplied by other traders’ orders.

What are agency/proprietary orders?• Orders submitted by traders for their own account are

proprietary orders.– Broker-dealers and dealers.

• Since most traders are unable to directly access the markets, most order are instead agency orders.– Presented by a broker to the market.

• Agency orders can be held or not held/worked.– Held orders are those when the broker has an obligation to a client to

fill the order.– Market-not-held orders are institutional orders where the trader hires

a broker-dealer to execute the order.– Working an orders means that a broker-dealer takes some time to fill

the order.

Market orders

• A market order is an instruction to trade at the best price currently available in the market.– Immediacy

– Buy at ask/sell at bid => pay the bid/ask spread

– Price uncertainty

• Suppose the quotes for ABCD are a bid of $50.00 and an offer of $50.50, what is the transactions costs for a trader using a market buy order in ABCD?– Why?

– What is the best estimate of the value of ABCD?

Price improvement

• Price improvement is when a trader is willing to step up and offer a better price than that of the prevailing quotes (at order arrival).

• Who benefits from price improvement?

• Who looses from price improvement?

• Should it be allowed to offer price improvement?

• Should everyone be allowed to offer price improvement?

• Does your answer depend on the minimum price increment in the market?

Market impact• Large market orders tend to move prices.• Liquidity might not be sufficient at the inside quotes for

large orders to fill at the best price.– For example, suppose that a 10K share market buy order arrives in

IBM and the best offer is $100 for 5K shares. – Half the order will fill at $100, but the next 5K will have to fill at

the next price in the book, say at $100.02 (where we assume that there is also 5K offered).

– The volume-weighted average price for the order will be $100.01, which is larger than $100.00.

• Prices might move further following the trade.– Information and liquidity reasons.

Limit orders• A limit order is an instruction to trade at the best price available, but

only if it is no worse than the limit price specified by the trader.– OK to trade at or above the limit sell price.

– OK to trade at or below limit buy price.

• If the limit order is executable (marketable), than the broker (or an exchange) will fill the order right away.

• If the order is not executable, the order will be a standing offer to trade.– Waiting for incoming order to obtain a fill.

– Cancel the order.

• Standing orders are placed in a file called a limit order book.

Limit order placement

Limit price placement Buy orders

Above the best offer Marketable (aggressive)

At the best offer Marketable

Between the best bid and offer

In the market

At the best bid At the market

Below the best bid Behind the market

Away from the market

Limit orders are trading options• Limit orders offer other traders an option to trade, that is

they supply liquidity.– Sell limit orders are call options that give traders the right to buy.

– Buy limit orders are put options that give traders the right to sell.

• What is the option strike price?

• How are limit orders different from regular option contracts?

• On what factors does the value of the option to trade depend?– How do these factors impact the bid ask spread?

Why would anyone use limit orders?

• The compensation that limit order traders hope to receive for giving away free trading options is to trade at a better price.

• However, options might not fill (execution uncertainty).– Chasing the price.

• Limit order traders might also regret having had their order filled (adverse selection)…– What could cause a limit order to regret obtaining a fill?

– How would this fact affect strategies involving limit orders?

Other order types• A stop instruction stops an order from executing until price

reaches a stop price specified by a trader.– Buy only after price rises to the stop price.– Sell only after price falls to the stop price.– Can be either stop market or stop limit orders.– How are stop limit orders different from regular limit orders?– How do stop orders affect liquidity?

• Market-if-touched orders become a market order when price reaches some preset touch price.– Buy when market falls to the touch price.– Sell when market rises to the touch price.– How are MIT orders different from regular limit orders?– Do MIT orders demand or supply liquidity?

Tick-sensitive orders

• Traders who want to condition their orders on the last price change submit tick-sensitive orders.– Uptick = current price is above the last price

– Downtick = current price is below the last price

– Zero-tick = current price is the same as last price

• Do tick-sensitive orders demand or supply liquidity?

• How do tick-sensitive orders compare to limit orders?

• How are tick-sensitive orders affected by the minimum price-increment?

Additional order instructions• Day orders (DAY)• Good-til-cancel (GTC) orders• Good until orders• Good-this-week (GTW) orders,

good-this-month (GTM) orders• Immediate-or-cancel (IOC)

orders• Fill-or-kill (FOK) orders, good-

on-sight orders• Good-after-orders• Market-on-open (MOO) orders• Market-on-close (MOC) orders

• All-or-none (AON) orders• Minimum-or-none (MON) orders• All-or-nothing, and minimum

acceptable quantity instructions

• Spread orders• Display instructions

– Hidden/Ice-berg orders/reserve• Substitution orders

• Special settlement instructions– Regular-way settlement– Cash settlement– How do these affect the cost of

trading?

Market Structures

Market structures• The trading rules and the trading systems define a market’s

market structure.• Call markets versus continuous markets.

– Call markets allow trades only when the market is called (rotation among securities).

– Continuous markets allow trades anytime during regular trading hours.

– Hybrids of course exist (NYSE, the LSE and soon Nasdaq)– Which one would you prefer, and why?

• Trading hours.– Most markets limit their regular trading hours.– Should markets be open around the clock?

Quote-driven markets• Dealers supply the liquidity

– Dealers participate in every trade– Dealers may trade with each other (interdealer trading).– Why would dealers need to trade with each other?– How should a customer or broker decide which dealer to approach

to trade?

• Examples of quote-driven markets– The Nasdaq Stock Market, Inc.– The London Stock Exchange (less liquid stocks)– eSpeed government bond trading system– Reuters 3000 foreign exchange dealing system

Order-driven markets• Rule based order handling and trading

– Order precedence rules– Trade pricing rules– Auction markets– Single price (calls), continuous two-sided auctions, crossing

networks– Can a dealer trade in an auction market?

• Examples of order-driven markets include:– Futures exchanges– Stock and options exchanges– ECNs– Markets for new issues of government debt

Brokered markets

• Brokers match up buyer and seller.– Search is often required to match buyer and sellers for less liquid

items, and for large blocks of securities

– Brokers specialize in locating counterparts to difficult orders

– Concealed traders

– Latent traders

• Examples of brokered markets include:– Block trading (stocks and bonds)

– Real estate

– Business concerns

Market information systems• It is of utmost important that orders are not lost and that

order instructions are understood.– Ticker symbols– Order routing systems– Order presentation systems– Messaging systems

• The information created by trading is valuable.– Market data systems report trades to the public– Broadcast services

• Price and sale feeds• Ticker tapes• Quotation feeds

• Transparency is a key feature of markets.– Ex ante vs. ex post transparency

Limit Order books versus Call Markets

Order Driven Markets

• Trading rules based markets.– Oral auctions– Single price auctions– Continuous electronic auctions– Crossing networks

• The most popular form for new markets.• Order precedence rules match buyers to sellers.• Trade pricing rules price the resulting trades.

Oral auctions• Used by many futures, options, and stock exchanges.

– The largest example is the US government long treasury bond futures market (CBOT, 500 floor traders).

• Traders arrange their trades face-to-face on an exchange trading floor.– Cry out bids and offers (offer liquidity)– Listen for bids and offers (take liquidity)– “Take it” = accept offer– “Sold” = accept bid

• Open outcry rule– Traders must publicly announce their bids and offers so that all other

traders may react to them (no whispering…).– Traders must also publicly announce that they accept bids/offers.– Why is this necessary?

Oral auctions

• Order precedence rules– Price priority

• Should a trader be allowed to bid below the best bid, above the best ask in an oral auction?

– Time precedence (futures markets)• Is time precedence maintained for subsequent orders at the best bid or

offer? Why? Why not?

• How can a trader keep his bid or offer “live”?

• The minimum tick size is the price a trader has to pay to acquire precedence.

– Public order precedence, time precedence (stock markets)• Why do you think this is necessary?

Oral auctions

• Trade pricing rule– Trades take place at the price that is accepted, i.e., the bid or offer.

– Discriminatory pricing rule.• Why do you think it is called discriminatory? Who gets the surplus?

• Trading floors can be arranged in several rooms as on the NYSE, with each stock being traded at a specific “trading post.”

• Trading floors can also be arranged in “pits” as in the futures markets.

Rule-based order-matching systems• Used by most exchanges, some brokerages, and almost all ECNs.• Trading rules arrange trades from the orders that traders submit to

them.• No face-to-face negotiation.• Most systems accept only limit orders.

– Why do you think most systems are reluctant to accept market orders?• Orders are for a specified size.• Electronic trading systems process the orders.• Trades may take place in a call, or continuously.

– A new order arrival “activates” the trading system.• Systems match orders using order precedence rules, determine which

matches can trade, and price the resulting trades.

Rule-based order-matching systems• Order precedence rules.

– Price priority• Market orders always rank above limit orders…

– Time precedence• Strict time precedence• Floor time precedence to first order at price.

– All subsequent orders at that price have parity

– Display precedence• Why do markets use display precedence?

– Size precedence• Some markets give precedence to small orders, other markets favor

large orders (NYSE).• Why would a market give precedence to large orders?

Example – Pure price-time precedence

Time Trader Buy/Sell Size Price12:02 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

12:27

Bill

Seth

Buy

Sell

200

200

$20.05

$20.10

Example – the order book

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 $20.05 200 Bill

Steve 200 $20.06 500 Bern

$20.08 100 Bob

Susie 300 $20.08 500 Bev

Seth 200 $20.10

Sandy 500 $20.12

Infinite 200 Ben

Clearing the order book with a call at 12:30

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05 200 Bill

Steve 200 100 0 $20.06 500 Bern

$20.08 100 Bob

Susie 300 0 $20.08 500 200 Bev

Seth 200 $20.10

Sandy 500 $20.12

Infinite 200 0 Ben

Trades in the example - call

Buyer Seller Quantity Price?

Ben Sammy 100 Infinity, $20.05

Ben Steve 100 Infinity, $20.06

Bob Steve 100 $20.08, $20.06

Bev Susie 300 $20.08

Example – the order book after the call

Sellers Buyers

Trader Size Price Size Trader

$20.05 200 Bill

$20.06 500 Bern

$20.08 200 Bev

Seth 200 $20.10

Sandy 500 $20.12

Example - What should be the price/prices?

• Possibilities include:– Infinite– $20.05– $20.06– $20.08

• The price/prices depends on the trade pricing rules.• Single price auctions use the uniform pricing rule

– Everyone gets the same price.

• Continuous two-sided auctions and a few call markets use the discriminatory pricing rule.– Trades occur at different prices.

• Crossing networks use the derivative pricing rule.– The price is determined by another market.

Uniform pricing rule• All trades take place a the same “market clearing price.”

– The market clearing price is determined by the last feasible trade.• Matching by price priority implies that this market clearing price is also

feasible for all previously matched orders.

– If the buy and sell orders in the last feasible trade specify different prices, the market clearing price can be at either the price of the buy or the price of the sell order.

• The trade pricing rules will dictate which one to use.

• In Example 1, the last feasible trade is between Bev and Susie, so the market clearing price is $20.08.– Sam, Steve and Susie are happy with a market clearing price of $20.08

since they were willing to sell at $20.08 or lower.– Ben, Bob, and Bev are happy to with a market clearing price of $20.08

since they were willing to buy at $20.08 or higher.

Supply and Demand• The single-price auction clears at the price where supply equals demand.

– At prices below the market clearing price, there is excess demand.– At prices above the market clearing price, there is excess supply.

• Single price auctions maximize the volume of trading by setting the price where supply equals demand.

– Because prices in most securities markets are discrete, there is typically excess demand or excess supply at the market clearing price.

– In the Example, what is the excess demand or supply?• The single price auction also maximizes the benefits that traders derive

from participating in the auction.– Trader surplus for a seller = the difference between the trade price and the

seller’s valuation– Trader surplus for a buyer = the difference between the buyer’s valuation and

the trade price.– Valuations are unobservable, but we may assume that they at least are linked

to limit prices.

Example: Demand and Supply

$20.04

$20.05

$20.06

$20.07

$20.08

$20.09

$20.10

$20.11

$20.12

$20.13

0 300 600 900 1200 1500

SupplyDemand

Discriminatory Pricing Rule• Continuous two-sided auction markets maintain an order book.

– The buy and sell orders are separately sorted by their precedence.• The highest bid and the lowest offer are the best bid and offer respectively.

– When a new order arrives, the system tries to match this order with orders on the other side.

• If a trade is possible, e.g., the limit buy order is for a price at or above the best offer, the order is called a marketable order.

• If a trade is not possible, the order will be sorted into the book according to its precedence.

• Under the discriminatory pricing rule, the limit price of the standing order dictates the price for the trade.

• If the incoming order fills against multiple standing orders with different prices, trades will take place at multiple prices.

Continuous trading @12:02

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 $20.05

$20.06

$20.08

$20.08

$20.10

$20.12

Infinite

Continuous trading @12:06

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 $20.05

Steve 200 $20.06

$20.08

$20.08

$20.10

$20.12

Infinite

Continuous trading @12:15

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

$20.08

$20.08

$20.10

$20.12

Infinite

Continuous trading @12:16

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

Susie 300 $20.08

$20.08

$20.10

$20.12

Infinite

Continuous trading @12:20

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

Susie 300 100 $20.08

$20.08

$20.10

$20.12

Infinite 200 0 Ben

Continuous trading @12:21

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

Susie 300 100 0 $20.08 100 0 Bob

$20.08

$20.10

$20.12

Infinite 200 0 Ben

Continuous trading @12:24

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

Susie 300 100 0 $20.08 100 0 Bob

$20.08

$20.10

Sandy 500 $20.12

Infinite 200 0 Ben

Continuous trading @12:25

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05

Steve 200 0 $20.06 500 200 Bern

Susie 300 100 0 $20.08 100 0 Bob

$20.08 500 Bev

$20.10

Sandy 500 $20.12

Infinite 200 0 Ben

Continuous trading @12:27

Sellers Buyers

Trader Size Price Size Trader

Sammy 100 0 $20.05 200 Bill

Steve 200 0 $20.06 500 200 Bern

Susie 300 100 0 $20.08 100 0 Bob

$20.08 500 Bev

Seth 200 $20.10

Sandy 500 $20.12

Infinite 200 0 Ben

Summary continuous trading

Buyer Seller Size Price Bid Offer

$20.05x100

$20.06x100

Bern Sammy 100 $20.05

Bern Steve 200 $20.06

$20.06x200

$20.06x200 $20.08x300

Ben Susie 200 $20.08

$20.06x200 $20.08x100

Bob Susie 100 $20.08

$20.06x200

$20.06x200 $20.12x500

$20.08x500 $20.12x500

$20.08x500 $20.10x200

Discriminatory versus uniform pricing rules

• Taking the orders as given, large impatient traders prefer the discriminatory pricing rule.

• Taking the orders as given, standing limit order traders prefer the uniform pricing rule.

• However, orders are not given.– Limit order traders tend to price their orders more aggressively in

the under the uniform pricing rule.– Can you explain this prediction?– Why would large traders want to split their orders when trading

under the uniform pricing rule?– What role can trading halts have in affecting the pricing rules?

Continuous versus call markets• The single price auction produces a larger trader surplus

than the continuous auction when processing the same order flow (example).– Concentration of order flow increases total trader surplus.– In practice, traders will not send the same order flow to call and

continuous markets.• The single price auction will typically trade a lower

volume than the continuous auction.– In our example, both trade 600 shares…

• However, there is another benefit of the continuous market – it allows traders to trade when they state their demands.

The derivative pricing rule and crossing networks

• Crossing networks are the only order-driven markets that are not auction markets.– All trades take place at a price discovered elsewhere.

• Who owns prices discovered in primary markets?– Discover how much buy and sell volume there is at the crossing

price.– ITG’s POSIT, Instinet’s Global Instinet Crossing, and the NYSE’s

After-hours Trading Session I.• Second chance at getting the closing price (4pm)

• Crossing networks are call markets to which traders can submit limit orders and market orders.– Order precedence rules determine which orders will trade after the

crossing price has been announced.

The derivative pricing rule and crossing networks

• POSIT runs 8 crosses per day.– Choosing a time at random in the 7 minutes following the crossing time.

• Why do you think they are randomizing the timing?– Permits traders to fill their orders at the mid-quote, without price impact.– Crosses are completely anonymous and order imbalances are never

disclosed.• Why do you think this is attractive to traders?

• Crossing networks almost invariably have excess demand or supply.– Order precedence rules.– Rationing mechanism.– Less than 10 percent of their order volume ever crosses.– Commissions are reasonable, 1-2c/share.

Problems with derivative prices• Stale prices and well-informed traders

– Crosses take place with some delay relative to the reference price.– Between the trade and the establishment of the reference price,

news might have been released.• After-hours trading at Regionals and ECNs…

– Adverse selection (well-informed traders)

• Price manipulation– Temptation to manipulate the price in advance of the cross.– Particularly a problem in less liquid stocks.

• Push prices down (up) if anticipate to buy (sell) in the cross.

– Illegal, but difficult to detect and prosecute.

Microstructure Data

Transactions data

• Massive datasets!• The degree of detail varies considerably across

datasets– London QMG data– TAQ – trades no ids and BBO (1993-today)– Nastraq – trades no ids and dealer quotes ids (1998-

2004)– TORQ – orders, audit trail, and BBO, some ids (1990)– BDM – orders, trades, by type– Islad – order, trades, by type

Calor Group trades Jan. 14, 1991239 0 277 A 831 3426 420 PM 834 3426 A243 0 398 I3 844 50000 278 PM 845 50000 A243 0 594 I3 845 50000 278 PM 846 50000 A240 0 278 PM 854 50000 278 A 854 50000 A E238 0 910 PM 1052 500 419 A 1053 500 A240 0 910 PM 1102 20000 921 A 1102 20000 A241 8790 278 I3 1103 10000 910 PM 1103 10000 A238 0 910 PM 1133 850 545 A 1133 850 A238 0 910 PM 1154 636 189 A 1154 636 A243 0 398 A 1231 15000 398 MX 1231 15000 A E238 0 398 PM 1247 1000 248 A 1247 1000 A238 0 420 PM 1319 101 346 A 1319 101 A238 0 420 PM 1437 466 346 A 1437 466 A238 0 420 PM 1533 275 346 A 1533 275 A239 0 278 PM 1554 6500 278 A 1554 6500 A E238 0 910 PM 1614 500 865 A 1614 500 A238 0 591 P 1615 1700 248 A 1629 1700 A

Price Buyer information Seller information Flags

MMID

Capacity

Time

Size

MMID

Capacity

Time

Size

Calor Group quotes Jan. 14, 199181546 163241 230 0 25000 220 0 25000 O 91082530 105531 232 0 25000 222 0 25000 O 36282629 85646 232 0 10000 222 0 10000 O F 3682852 105521 232 0 10000 222 0 10000 O 59482907 83813 230 0 25000 220 0 25000 O 27882947 103334 232 0 25000 222 0 25000 O 683814 105530 230 0 25000 220 0 25000 27885647 105544 231 0 10000 221 0 10000 F 3690259 91036 232 0 25000 222 0 25000 O 39891532 105523 232 0 25000 222 0 25000 O 398103335 105503 230 0 25000 220 0 25000 6105504 111950 228 0 25000 218 0 25000 6105522 164418 230 0 10000 220 0 10000 594105524 164327 230 0 25000 220 0 25000 398105531 164418 228 0 25000 218 0 25000 278105532 164019 230 0 25000 220 0 25000 362105545 105738 230 0 10000 220 0 10000 F 36105739 163051 229 0 10000 219 0 10000 F 36111951 164030 225 0 25000 215 0 25000 6

Market Maker IDStart

End

Bid AskBsize Asksize Flags

TAQ data

• Period covered is 1993-today• Available either on CDs or via WRDS• All trades in NYSE-, Nasdaq-, Amex-listed

stocks.• Trade information (Time, Price, Size, Flags)• BBO (inside quotes from each market)• We will use this data for Project II IBM (7/2002)

Nastraq data

• Period covered is 1998-today.• Available either on CDs or via WRDS• All trades in Nasdaq-listed stocks.• Trade information (Time, Price, Size, Flags)• BBO (inside quotes from each market)• Dealer quotes (quotes from each market maker)• We will use this data for Project II MSFT (7/2002)

TORQ data

• 144 NYSE stocks from size deciles

• Nov 1, 1990 – Jan 31, 1991

• Transactions

• BBO

• Order data– Submissions

– Revisions

– Cancellations

– Executions

• Audit trail

BDM data

• We will use this as an example of data from an electronic limit order market.

• Trades

• Orders– Order submissions

– Order revisions

– Order cancellations

– Order executions

• Build limit order book

• Create inside quotes

Ticker Date Time Price Volume Put-throughSeq

A=Buy

V=Sell

Order ref Begin date End date Chaining code Entry date Entry time

Order size Discl. Size

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

Price

J=EDO, D, R=GTC, L=GTC, E=FOK

J=EDO, D, R=GTC, L=GTC, E=FOK

Agency auction/ floor: NYSE• One designated MM/stock, 9 specialist firms.

– Specialist participation rate is less than 20%.• SuperDot

– Handles 85% of orders, of value• OARS• Floor brokers manually trade orders

– Represent roughly 50% of value traded• Crowd = floor brokers and specialist• Direct+, OpenBook

– New features• Upstairs facilitated trades

Specialists’ affirmative obligations• Specialists are traders of last resort.

– Have to quote firm two-sided markets during trading hours.

• Specialists have an obligation to smooth prices by intervening to prevent large price reversals (provide price continuity).– Expensive if informed traders in the market.– Profitable if liquidity is low because other traders are distracted.

• Exchanges regularly evaluate specialists based on the width of their quotes, the depth at their quotes, and price continuity.

• Specialists provides– Liquidity when there are order imbalances– Price continuity– Limit order display– Supposedly stabilize prices

Specialists also do…

• Specialists represent system order flow.– Orders that are routed electronically to the exchange for execution.

– Specialists get compensated for this service in the form of commissions (for orders that stay on the book (NYSE>5 min)).

• Specialists also work orders entrusted to them by floor brokers (CAP, go-along orders).

• Specialists act as bulletin boards.

• Specialists have a responsibility to make sure that all traders follow the exchange rules.– Conduct an orderly market.

Specialist privileges• Specialists can engage in:

– Speculative trading on their own account.– Quote-matching– Cream-skimming

• Observe broker IDs for incoming orders…– Strategies to take advantage of stop orders

• Specialists control the quotes– Limit display to top-of-file– Constrained by order exposure rules

• Specialists can stop incoming marketable orders.• Specialists conduct the open.• Specialists receive brokerage commissions for system orders.• Specialists have a unique information advantage that they can use to

generate dealer profits.

Specialists’ negative obligations

• Abide by order preference rules, including public order preference.

• Public liquidity preservation principle is typically enforced at primary exchanges.– Specialists can trade only with incoming marketable orders.

• Third market dealers and regional specialists are generally not subject to the public liquidity preservation principle.– Dealers’ benefit of trading against stale limit orders is somewhat

offset by limit order price protection guarantees.

Dealer market Nasdaq/Seaq

• Two or more market makers per stock.

• Trades were mainly phone negotiated.

• Roughly 95% of the volume went through MM book.

• No central limit order book.

• Small order execution automated, but not larger orders.

• Complete decentralization

• ATS/ECNs

• Upstairs trading

Market maker obligations

• Provide quotes during trading hours• Offer “best execution”• Report trades in a timely manner• Fair communication• No churning

Electronic Trading Platforms

• Centralized order-driven market with automated order routing.

• Decentralized computer network for access.• Member firms act as brokers or principals.• No designated market makers• Central limit order book/information

system/clearing and settlement• Off-book trading is sometimes significant