Financial Markets

Lecture Notes 1 Market Microstructure: Institutions

Stefan Arping University of Amsterdam

Agenda
What is market microstructure research? Key concepts: Bids, asks, and spreads Order types Market eciency Market liquidity Trading motives: why do people trade? Market classications/features: Trade frequency Trade location Trade intermediation Trading rules Order & quote driven markets Market making and inventory concerns 2

Market Microstructure

Question: What is market microstructure research? Loose denition: market microstructure research examines how the process by which securities are traded aects prices, trading volumes, and the behavior of traders as such, we will examine the interplay between the rules of the trading environment (and the types of market participants involved) and the outcome of the trading process this means that we will need to examine the ways in which actual nancial markets/exchanges are organized and attempt to explain/model/evaluate them Traditional asset pricing theory (e.g., CAPM): ignores the trading process entirely. Concentrates on demonstrating the existence of market equilibria and the pricing of securities without concern for how such equilibria are actually attained in the real world and how such prices are formed/discovered

Typical Microstructure Questions

Here are some examples to give you a avor of the kind of issues we will look at: How should a NYSE market maker set his quotes if he believes that a fraction of his potential trading partners have inside information but he cannot identify who is informed? What is role of trade intermediaries / market makers? Does the trading mechanism of an exchange aect the speed with which new information is incorporated into prices? How do trading arrangements aect trading costs? If traders can operate in more than one trading venue which venue will they choose and why? When and why is a merger between two securities markets good and when is it bad? To begin we will introduce some basic concepts which we will use throughout our analysis.

Key Concepts

Bids, asks, and spreads

Order types

Market eciency

Market liquidity

Bids, Asks, and Spreads

One thing you will notice if you check out stock prices online is that there are often two prices quoted for every stock. These are the Bid: price one would receive for an immediate sale of a unit of stock Ask: price charged for immediate purchase of stock. Also called oer. Obviously, the ask price should exceed the bid price. Why? The dierence between the ask and the bid price is called the BidAsk Spread: as discussed above, the spread will be positive Always remember that the bidask spread is the dierence between the ask and the bid (rather than the dierence between the bid and the ask). There are various reasons for the existence of the bidask spread which we will discuss later on. In practical terms, the spread can be thought of as measuring the cost of the desire to trade instantly.

Types of Orders
In general, one can submit two types of order to markets: Limit Orders: are price contingent. If, for example, one submits a limit order to buy 100 shares of ING at (at most) 6 EUR per share then the order will be only executed if a seller exists who is willing to give you his shares for 6 EUR or less. The major problem with limit orders is that sometimes such a seller will not be present. Hence there is execution uncertainty. Market Orders: are requests to buy/sell immediately which do not specify a price. Hence, a market order to buy 100 ING shares would execute with certainty at the best price available. Note that this implies that there is price uncertainty. Hence, the basic tradeo is between price and execution uncertainty. For example, patient traders are likely to choose limit orders impatient traders are willing pay a premium for instant execution and hence use market orders.

Market Eciency

Denition: A market is said to be informationally ecient with respect to a given information set if no agent can make a prot by trading on . Economic prot is dened as the level of return after costs adjusted appropriately for risk.

Bottom line: If a market is ecient then the reward one gets for trading on a position is only that due to the risk of the position or due to information which is not contained in .

Weakform Eciency: if we dene to contain public information only, then the market is said to be weakform ecient. An implication of weakform eciency is that past/current outperformance does not predict future outperformance. In practical terms, this means that technical analysis is useless. By contrast, weakform eciency does not preclude the possibility that one can trade protably on private/inside information. Strongform Eciency: if we dene to contain public and private information, then the market is said to be strongform ecient. Strongform eciency precludes the possibility that one can prot from private/inside information. Q: at rst sight, it may seem silly to assume that a market is strongform ecient. Is it? 8

Market Eciency

the concept of market eciency is frequently misunderstood (e.g., in the press) informational eciency does NOT say that markets are: well-functioning, perfect, or fair not subject to bubbles and crashes self-governing and not in need of regulation it merely says that its hard to beat the market, i.e., to make prots above and beyond those required to compensate for risk it is easy to generate excess returns (expected return > risk-free rate): just take more (systematic) risk! it is much harder to generate excess returns adjusted for risk! in essence, market eciency merely says that if a trading strategy sounds too good to be true it probably is! in practice, markets are probably not completely ecient and not always so, but for most practical purposes taking market eciency as given is a good starting point 9

Market Liquidity
What is (market) liquidity? Partial Answer: markets are often termed liquid if trading costs are low and if volumes are high. From a practical viewpoint this implies that altering your portfolios composition is not likely to be expensive and also not likely to be dicult (in that nding a trading partner is relatively easy). A more complete denition is given by Kyle (1985), which we will discuss later on. He denes a liquid market as one which is tight: costs of trading small amounts are themselves small (i.e., bidask spreads are small) deep: costs of trading large amounts are small too big trades do not cause large price movements resilient: discrepancies between prices and true values for an asset are small and corrected very quickly.

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Market Liquidity

Note that Kyles denition encompasses several types of costs (small and large trading costs and the cost of trading at prices which do not adequately reect fundamentals) Most empirical microstructure research has concentrated on measuring liquidity through measurement of bidask spreads, i.e., the focus is on tightness People who run markets care about liquidity as it is a key factor in competition between markets. Moreover, it is often said that liquidity leads to liquidity: A highly liquid market is a desirable trading venue This leads to increased numbers of trades being executed on the market This in turn increases liquidity.

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The Many Facets of Liquidity

The term liquidity can have dierent meanings: market liquidity: how easy/cheap is it for you to take or unwind a position? (this is what we focus on!) savings liquidity: how much cash do people hold in their cons which they could potentially invest? (in essence, this is what people mean when they say that markets are awash with liquidity) credit liquidity: how easy is it to obtain external funding for valuable investment opportunities? The 2007-2009 credit market crisis was characterized by a lack of market liquidity: banks had a hard time unwinding their positions at good prices credit liquidity: banks had a hard time getting credit to renance their mortgage conduits Q: how may savings liquidity have caused (or contributed to) the crisis?

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Trading Motives: Why Do People Trade?

diversication / portfolio rebalancing / risk management liquidity needs: you may need cash; to satisfy your liquidity needs you sell part of your portfolio. satisfying client needs: for example, a mutual fund may be forced to sell part of its portfolio in order to satisfy withdrawals. Conversely, it may have to buy following fresh cash inows. information: you may have information other people dont have. You may be able to make a prot on this information. control: shares have voting rights. Thus, to obtain control in a rm, you may want to buy this rms shares. fun/stupidity/speculation: some people trade because they think its fun, because they do not understand the rules of the game, or because they think they can make a prot by speculating. Q: in ecient markets, can it be rational for banks to engage in purely speculative trading?

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Essential Market Characteristics

We will now describe the important distinguishing features of actual nancial marketplaces. Thus we will discuss how, where and when trading actually occurs, who is involved in the trading process and who can observe the details of trading. We will look at the following features: When trading occurs Where trading occurs Trade intermediation The rules and regulations governing trade

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Trade Frequency
Call auctions (or batch markets): Trade only takes place at a (small) number of prearranged times during the day In the period running up to these times, agents often submit limit orders The exchange aggregates limit buys and sells into demand and supply curves When the auction is called, the demand/supply curves are crossed and orders are executed at the market clearing price Call auctions are often used for: Trade in illiquid securities: for thinly traded stocks or on emerging market stock exchanges Market openings: call auctions are often used during the rst few minutes of a days trading to determine an opening price Trading restarts: if for some reason trading has been halted (say for lunch) then it may be restarted with a call auction

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Sequential markets (or continuous auctions): Trades execute continuously as and when buyers and sellers meet (physically, electronically, or over the phone) In between opening and closing times of the market, no regulation on when transactions take place Trades take place at whatever price is agreed between two counterparties to trade

Most developed markets employ (variants of) the continuous auction in major trading venues for liquid securities. Many popular continuous auction type markets are pretty much entirely electronic. There are still some, albeit very few, auction based open outcry markets were individuals physically meet on a trading oor, such as the Chicago Board of Trade (CBOT), established in 1848. http://en.wikipedia.org/wiki/Chicago_Board_of_Trade

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Chicago Board of Trade

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Trading Location
Centralized markets: Buyers and sellers meet in the same location at which trading occurs Location may be a physical are such as a trading oor or an electronic location to which all traders are linked via a computer Centralization makes regulating and monitoring markets more straightforward

Decentralized markets (over-the-counter): Trading takes place in many physically/electronically distant locations Individual dealers contact other dealers bilaterally to request prices. Any trade which may result is usually unknown to other market participants Hard to regulate and monitor whats going on in these markets because theres no place where activity is concentrated. Note: the vast majority of trading takes place in decentralized markets! 18

Global FX Turnover

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Global FX Turnover

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Global FX Turnover

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Trade Intermediation
Market Makers: In quotedriven markets a market maker or dealer is on one side of every trade The market maker provides quotes and stands ready to buy and sell at these quotes (he/she is said to provide liquidity) Dealers hold an inventory of the security, which uctuates as he trades Market makers prot from charging the bidask spread and from speculating

Brokers: In brokered markets, brokers perform an active role to match buyers and sellers Hence, they do not provide liquidity themselves; they merely nd liquidity As brokers do not actually participate in the trade itself, they have no inventory concerns

Many markets have no intermediaries at all. These are purely orderdriven markets. 22

Trading Rules and Regulations

In most (centralized) market places, sets of rules exist which regulate the process by which transactions take place. The most important of these rules are called priority rules. These rules determine the sequence in which existing (limit) orders execute against incoming (market) orders. Price priority: the best price orders execute rst. Hence the buyer willing to pay the most (or the seller willing to accept the least) is satised rst Time priority: the order entered rst (in terms of calendar time) is satised rst known as the rst come, rst served Size priority: the orders for the largest amount of shares/units is satised rst. Hence a limit sell for 1000 shares would be ahead of another limit sell for 750 shares in the execution queue. In practice, these rules are employed simultaneously with a hierarchy imposed. Generally price priority is most important, then time priority and nally size priority.

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Order Driven Markets: Example

We now study a set of examples of the operations of order driven markets. Liquidity is supplied to the system via limit orders and drained via market orders and limit order crosses. Orders are ranked by price, then time and size priority. The limit order book opens at date 0. Table 1: Order book at the open Sell orders 2000 7000 15000 10000 Price 103 102 101 100 99 98 97 Buy orders

5000 12000 4000 4000

Note that the limit order book (short, order book or book) contains a limit buy for 10000 shares at price 100 and a limit sell for 5000 shares at price 100. Hence, the buyer and seller can trade 5000 shares at 100 their limit orders have crossed. Practical example: http://www.six-swiss-exchange.com/knowhow/exchange/trading_en.html

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Crossing Limit Orders

Table 2a: Order before cross Sell orders 2000 7000 15000 10000 Price 103 102 101 100 99 98 97 Buy orders

5000 12000 4000 4000

Table 2b: Order book after cross Sell orders 2000 7000 15000 5000 Price 103 102 101 100 99 98 97 Buy orders

12000 4000 4000

Hence, the bidask spread is given by 1 unit of currency.

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A Market Order Arrives

At date 2 a trader submits a market order to buy 5000 shares. This order will execute against the limit sell order(s) at price 100 and leaves the order book as shown below with a spread of 2: Table 3a: Order book before market buy Sell orders 2000 7000 15000 5000 Price 103 102 101 100 99 98 97 Buy orders

12000 4000 4000

Table 3b: Order book after market buy Sell orders 2000 7000 15000 Price 103 102 101 100 99 98 97 Buy orders

12000 4000 4000

The midpoint moves from 99.5 to 100. 26

Fresh Liquidity is Supplied

At date 3, a new limit sell is entered for 6000 shares at price 102 and, simultaneously, a limit buy enters at price 100 and for a quantity of 2000 shares. Table 4a: Order book before new limit order submission Sell orders 2000 7000 15000 Price 103 102 101 100 99 98 97 Buy orders

12000 4000 4000

Table 4b: Order book after new limit order submission Sell orders 2000 13000 15000 Price 103 102 101 100 99 98 97 Buy orders

2000 12000 4000 4000

Hence, the spread has moved back to 1 unit of currency. The midpoint is 100.5 27

A Big Market Order Arrives

Finally, at date 4, a market order to buy 29000 shares arrives. The order executes against the limit order(s) at 101, 102, and 103. Total cost is 15000 101 + 13000 102 + 1000 103 = 2, 944, 000 or 101.52 per share. Table 5a: Order book before big market order. Sell orders 2000 13000 15000 Price 103 102 101 100 99 98 97 Buy orders

2000 12000 4000 4000

Table 5b: Order book after big market order. Sell orders 1000 Price 103 102 101 100 99 98 97 Buy orders

2000 12000 4000 4000

Hence, the spread has moved to 3 units of currency and the midpoint to 101.5. 28

Quote Driven Markets: Example

Consider a market that is intermediated by three competing dealers, called A, B, and C. Each dealer publicizes bid and ask quotes along with the associated quantities for which they are good. The public can simultaneously see the quotes of all three dealers and are free to choose the dealer with whom they want to trade. Opening quotes are as follows with quantities in brackets. Table 6: Opening dealer quotes. Dealer A B C Inside Bid 94 (12000) 98 (5000) 93 (3000) 98 (5000) Ask 104 103 100 100

(5000) (7000) (4000) (4000)

The nal row of the table gives the inside quotes the best bid and ask quotes available after inspecting the prices of all three dealers. The inside spread is 2.

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A Trade at the Best Bid

Assume that a market sell order arrives for 5000 units. This hits Bs bid and after the trade (for 5000 units at price 98) he revises his quotes as shown: Table 7: Quotes after market sell. Dealer A B C Inside Bid 94 (12000) 90 (1000) 93 (3000) 94 (12000) Ask 104 101 100 100

(5000) (8000) (4000) (4000)

The reason why B lowers both the bid and the ask is that his inventory increased by 5000 shares. He doesnt necessarily want to increase his inventory further (at existing prices), so he decreases the bid to deter sells. He also decreases the ask to attract buys. The inside spread is now 6. The best bid (now posted by dealer A) is much lower than before. The best ask is unchanged, however.

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Quote Updating
Assume now that dealer C thinks that the inside spread of 6 is uncompetitively large and hence decides to revise his bid quote upwards. At the same time dealer A revises his ask quote downwards. This yields the following situation. Table 8: Quote updating. Dealer A B C Inside Bid 94 (12000) 90 (1000) 96 (6000) 96 (5000) Ask 100 101 100 100

(5000) (8000) (4000) (9000)

The spread has now fallen to 4 as dealer C has increased his bid. Also, there is increased size at the best ask as dealer A has reduced his quote to 100 to match that of dealer C.

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Competition Among Dealers

Now suppose dealer B decides to reduce his ask to 99 in order to be ahead of his competitors. Table 9: Quote updating. Dealer A B C Inside Bid 94 (12000) 90 (1000) 96 (6000) 96 (5000) Ask 100 (5000) 99 (8000) 100 (4000) 99 (8000)

The spread has fallen to 3 as dealer B has decreased his ask. If now a buy order of 5000 shares entered the market, it would hit Bs bid and he would be able to sell 5000 shares at 99. Had B not revised his bid, he would have missed that opportunity.

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Market Making and Inventory Concerns

NYSE: trading is facilitated through market makers (specialists) market makers specialize in one (or few) stocks http://usequities.nyx.com/listings/dmms these market makers make a market by quoting bids and asks and standing ready to buy from or sell to the public at these prices to be able to make the market, market makers need to hold inventory as market makers buy and sell, they inventory goes up or down as the market uctuates, the value of the inventory uctuates, too thus, market makers are subject to inventory risk to the extent that dealer is risk-averse (risk of costly bankruptcy, etc.), dealer must be compensated for inventory risk positive bid-ask spread (even in competitive markets)

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Market Making and Inventory Concerns

conclusion: market making is valuable as it allows people to trade instantly: it provides immediacy however, there is a cost since dealers must be compensated for being exposed to inventory risk market making is hugely important: NYSE is one example for dealer-facilitated trading, yet not the most important much trading in xed income, swaps, derivatives, FX, etc. is facilitated through market makers often it is banks that make markets in these securities recently: new regulations aimed at limiting banks engagement in proprietary trading (e.g., Volcker Rule) http://en.wikipedia.org/wiki/Volcker_Rule key question: how will such regulations aect market making and liquidity? we now examine a simple model to illustrate inventory concerns

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Stoll (1978): Model Setup

Consider a riskaverse dealer trading a single stock. The dealer has the following expected utility function dened over future wealth W : U (W ) = E [W ] /2 Var[W ] where > 0 measures the dealers aversion to risk The dealer has cash W0 and I units of the stock The future stock price v is uncertain with mean v and variance 2 The dealer posts bid and ask quotes, B and A. The dealer is willing to trade as long as doing so does not reduce his expected utility. He faces competition from other dealers so that the dealer makes zero prots (in utility terms) The dealer trades (either buys or sells) an amount Q I with the public We now derive the optimal bid and ask quotes.

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The Optimal Ask

If the dealer neither buys from nor sells to the public, what is his (uncertain) future wealth (WN )? WN = W0 + v I Conversely, if the dealer sells Q units of the stock his wealth level is: WS = W0 + AQ + v (I Q) Dealer just breaks even: U (W N ) = U (W S ) Consequently: E [W0 + v I ] /2 Var[W0 + v I ] = E [W0 + AQ + v (I Q)] /2 Var[W0 + AQ + v (I Q)] Now: Var[W0 + v I ] Var[W0 + AQ + v (I Q)] Solving for A: A= v 2 I Q 2 36 = = 2I 2 2 (I Q)2

The Optimal Bid

If the dealer buys Q units of stock, his nal wealth level is: WB = W0 BQ + v (I + Q) Optimal bid is determined through U (WN ) = U (WB ) Going through the same steps as above we get: B= v 2 I + which we assume to be positive. To summarize: optimal ask: A= v 2 I optimal bid: B= v 2 I + bid-ask spread: S = A B = 2 Q midpoint: M = (A + B )/2 = v 2 I 37 Q 2 Q 2 Q 2

Results of the Model

The model is relatively simple in specication yet it yields a number of interesting predictions: 1. Bid and ask quotes both depend negatively on dealer inventory, risk aversion, and inventory risk ( 2 ) 2. Sensitivity of quotes to inventory is increasing in risk aversion and inventory risk 3. Spread does not depend on level of inventory (bid and ask quotes adjusted by the same amount in response to inventory shocks), but the midpoint does 4. Spread does increase in trade size though 5. Sensitivity of spread to trade size depends positively on both dealer risk aversion and 2 Dealer is risk-averse and has a desired inventory of stock that he will attempt to get back to. Consequently, an increase in inventory is followed by a reduction in the ask (to encourage buy orders) and in the bid (to discourage additional sell orders), and a decrease in inventory is followed by an increase in the ask (to discourage further buy orders) and in the bid (to encourage sell orders). dealer buys Q new inventory I = I + Q both A and B go down dealer sells Q new inventory I = I Q both A and B go up 38

Take Home

market eciency market liquidity limit and market orders batch and sequential markets centralized and decentralize markets bidask spread limit order book trading motives market making and inventory concerns

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