CFA Institute

Equilibrium Exchanges
Author(s): Fischer Black
Source: Financial Analysts Journal, Vol. 51, No. 3 (May - Jun., 1995), pp. 23-29
Published by: CFA Institute
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Equilibrium Exchanges
FischerBlack
A frictionlessmarketfor exchangeswillfeaturean equilibrium
in whichtradersuse indexed
limit orders at differentlevelsof urgencybutdo not use marketordersor conventionallimit
orders.Buylimitorderswill matchsell limitordersat thecurrentprice.Limitorderentrywill
movepriceby an amountthatincreasesindefinitelyas urgencyincreases,so fasterexecution
meanshighereffectivecost. Dealerswill losemoney,so exchangeswill haveno specialistsor
marketmakers.Traderscansignalthattheyhaveno specialinformation
by using less-urgent
indexedlimitorders;theycannotdo betterby usingspecializedexchanges,sunshinetrading,
or baskettrading.

How do people trade in equilibrium? What

exchanges do they use, and what kinds of
orders do the exchanges offer? How do people
with and without private informationtrade?How
do more and less patient people trade?
In a competitiveequilibrium,anyone can start
exchanges, anyone is free to try to take over some
or all the business of other exchanges, and governments do not restrictthe rules that exchanges may
adopt. There are no restrictions on individual
tradersor on exchanges. Traderscan deal with one
another without going through exchanges. They
can trade anonymously through agents or through
exchanges.
An exchange that forces all traders to use
personal identification will not survive, because
many people value privacy, especially in financial
matters. Letting each trader choose whether to
identify himself seems pointless, because a person
intent on deceiving other traderscan then identify
his innocent trades while entering his devious
trades anonymously. Therefore, all trades are
anonymous.
This condition means that an informed trader
can imitate an uninformed traderif he can gain by
doing so, and an uninformed tradercan imitate an
informed trader. A tradercan break an order into
pieces if that reduces its impact on price. He can
put in a large order on one side and a small order
on the other side if that improves his expected
price for the net of the two orders.
Similarly, the exchange is free to use specialists or market makers or not to use them. An
Fischer Black is a partnerat Goldman, Sachs & Co. in New York.

exchange can offer a wide array of order types or

just a few. In particular,an exchange may choose
to allow anyone to imitate a one-sideddealerwhen
he wants to open or close a position.
In this market, every trader maximizes expected utility. Tradingprofits increase utility, and
trading delays reduce it. Nothing else affects utility. The price impact of an order can have a big
effect on trading profit.
Many traderscare only about expected profit.
They do not care about trading delays or risk. As a
result, they are quick to act on any profit opportunities created by predictable patterns in price
movements or by the arrivalof new public information. In equilibrium,however, these profit opportunities do not arise.
New information, no matter how perishable,
is referred to as news. Those who use it are news
traders.Those who trade for other reasons are nice
tradersbecause they are willing to lose what news
tradersmake if they cannot find a way to trade that
avoids those losses.
What does the unrestricted equilibrium look
like? The existing papers in the literature do not
ask this question. Some limit trading to one or two
rounds. All restricttradersand exchanges in ways
that significantly affect the resulting equilibria.
These restrictionsmake formalanalysis easier, but
the authors' conclusions cannot be generalized to
more realisticmodels.
For example, Grossman and Stiglitz used a
model with just one round of trading, so they
could not explore dynamic strategies and traders'
objectives could not include the disutility of waiting to trade.1Theirbasic idea, however, does carry

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23

over to a more general model. Trades by news

tradersand nice traderslook the same, so the noise
created by the nice traders acts as a cover for the
news traders.
Kyle extended the Grossman and Stiglitz
thinking to a world with multiple rounds of trading, but he assumed a severely restrictedstructure
of trading.2In his world, nice tradersare unable to
time their trades. They throw their trades at the
market in a seemingly random pattern and without warning. News traders can time their trades,
but they are not free to act as one-sided market
makers. Market makers are not free to invest in
information so they can trade on it.
If we try to generalize Kyle's model by relaxing its restrictions, its equilibrium collapses. For
example, a person without special informationcan
make a profit by first pretending to be a news
trader and then acting as a one-sided market
maker. He can open his position by buying aggressively and can close his position instantly by acting
as the askedside of a marketmaker, or he can open
by selling aggressively and close as the bidside of
a market maker. Eitherway, he makes a profit. A
world with profit opportunities is not in equilibrium.

Some models assume that everyone must

trade through dealers. For example, Glosten and
Milgrom and Grossman and Miller assumed that
outsidecustomers,both informed and uninformed,
must trade through a specialist or market maker
and cannot trade by quoting one side of the
market.3 When we relax this assumption, their
conclusions change completely.
Admati and Pfleiderer tried to describe an
equilibrium that includes sunshinetrading.4They
restricted their model by assuming that only a
trader without special information can preannounce a trade and that he cannot do any other
trading before executing his preannounced trade.
These restrictionsmake no sense when trading is
anonymous; without them, however, the equilibrium falls apart.
Glosten tried to describe equilibrium when
traders can use both limit orders and market orders, but he restricted his model by saying that
those who use marketorders cannot switch to limit
orders.5 In his model, a series of small market
orders on the same side can move the price a lot.
Thus, any trader who can switch from market
orders to limit orders, even if uninformed, could
move the price with market orders and then close
his position, usually at a profit, with limit orders.
He might even expect to gain by opening a posi-

24

tion with small market orders and closing with a

large market order. Thus, if Glosten's model describes equilibriumat all, it does so only in a very
restricted world. I see no way to enforce restrictions like this when trades are anonymous.
In contrast,I am trying to describeequilibrium
in an unrestricted world. I am only trying to
describe equilibrium;I am not trying to judge one
sort of exchange or method of trading as betteror
worsethan another. In particular,I do not assume,
as Harrisseemed to, that an exchange should favor
suppliersof liquidity over demandersof liquidity.6
If an equilibriumexists, it need not be Paretooptimal. When people trade on information, they
disclose it, at least in part, by moving prices. Early
disclosure has external benefits because it improves the allocation of resources; so we cannot
assume that people invest the right amount in
gatheringinformationon which they plan to trade.
With no external benefits, any amount spent on
informationwould be wasted (fromsociety's point
of view). Given the external benefits, the right
amount is positive, but it may be either higher or
lower than the equilibriumamount.
By restrictingtraders and exchanges heavily,
other authors create models that lend themselves
to formal analysis, but their conclusions do not
generalize to more realisticmodels. I am unwilling
to impose these restrictions,so I have been unable
to provide a full mathematicaldescription of equilibrium. Indeed, I cannot be sure that any equilibrium exists in my world, but I believe the resulting
generalityis worth the sacrificeof formalanalysis.
In the end, then, this entire articleamounts to
a series of conjecturesabout the nature of equilibrium, if one exists. I have been unable to provide
an exhaustive and precise analysis of the implications of my assumptions, but I would ratherguess
about what follows from more-relevant assumptions than derive precise conclusions from lessrelevant assumptions.

MARKET
ORDERS
A conventional market order can execute at a
single price (a single-pricemarket order) or at a
series of differentprices set by the limit orders on
the other side (an average-price
market order). A
news trader who uses a market order can trade
quickly to reduce the chance that others will trade
ahead of him on the same news, but the price
impact of his trade is a cost to him.
If a news trader uses a single-price market
order large enough to move the price by the full
value of his news, he expects no profit on the

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trade. Instead, he may try to use a series of

single-price market orders. He continues trading
until his expected profit from another small trade
is zero-that is, until he has moved the price by
the full value of his news.
Using a series of single-price marketorders is
tricky, however. Others may see what the traderis
doing and trade ahead of him, reducing the profit
he can make on his investment in news. To hide
his trades, he may spread them out, even though
this increases the risk that others may find out
what he already knows. He may even switch to
limit orders.
When a news trader can use average-price
market orders, he prefers them to single-price
market orders. An average-price market order is
executed as if it were a series of tiny single-price
market orders. The series of orders is executed all
at once, so no other traders can interrupt it. A
news trader pays or receives the average price of
all the tiny market orders rather than the final
price.

An average-pricemarket order is just what a

news trader wants, assuming that the exchange
offers him access to all who might take the other
side of his trade. He can trade quickly to minimize
the chance that others trade ahead of him on the
same news. He effectively breaks his trade into a
series of small trades without allowing others to
interrupt it, and he can choose a trade size that
moves the price by the full value of his news
without giving up any potential profit.
Roughly, marketdepthis the number of shares
it takes to move the priceby one small unit. A deep
market is more attractive to news traders than a
shallow market because they can execute larger
trades, which means more profits. Because news
trader profits are nice trader losses, a deeper
market is less attractiveto nice traders.
An exchange that allows average-pricemarket
orders dominates one that allows only single-price
market orders. Suppose the exchange sets market
depth so that news traderprofits are the same as if
it allowed only single-price market orders, which
means nice trader losses are also the same. With
average-price market orders, a news trader can
execute a single trade that moves the price by the
full value of his news. He need not camouflagehis
trades by spreading them out, which is costly to
him.
In equilibrium,then, anyone who uses a market order chooses an average-pricemarket order
when he can. Exchangesmight as well drop singleprice market orders from their lists of available

orders. They allow average-price market orders,

and their markets are shallower than if they offered only single-price market orders.
I can imagine an equilibriumin which all news
traders use average-price market orders and all
nice traders use limit orders, but only under very
restrictiveconditions. More generally, some news
traders in any trial equilibriumwant to use limit
orders, and some nice traderswant to use market
orders.
If both news traders and nice traders use
market orders, the meaning of a market order is
unclear.When a news traderuses an average-price
market order, he chooses a trade size that moves
prices by the full value of his news. When a nice
traderuses a marketorder, he distorts the priceby
an equivalent amount.
After a news trader'smarketorder, we expect
no further change in price; although after a nice
trader'smarketorder, we expect the price to revert
to its original level eventually. Taking both possibilities into account, we expect some reversion.
This reversion cannot be consistent with equilibrium, however, because it implies profit opportunities for traders who simply watch the sequence
of trades. On average, the price change caused by
a market order is partly reversed.
If all nice traders are sufficiently patient, we
can have an equilibriumin which news tradersuse
marketorders and nice tradersuse limit orders. In
general, though, some nice traders are impatient
and some news tradersare patient, so this equilibrium collapses. We can have equilibrium only if
exchanges do not offer market orders at all!

LIMIT
ORDERS
Conventionallimit orders are awkward to use. If a
traderputs in a large limit order at a single price,
anyone who knows about his order can take advantage of him. For example, a large limit order to
buy at 40 invites someone to put in a small limit
order to buy just above 40. If this small order
executes and the price rebounds, that trader can
realize a substantialprofit. If the price continues to
fall, it will pause at 40, and he can close his position
with a small loss. In effect, a person who puts in a
large limit order at a single price gives away
valuable options to traders who know about it.
A limit order at a single price rapidlybecomes
outdated. In fact, because market conditions
change so fast, the limit price on an order is often
outdated before it reaches the market. To avoid
these problems, people sometimes scale their limit
orders, putting in a series of sell orders at increas-

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25

ing prices or buy orders at decreasing prices.

Scaling is costly, however. A trader starts with
many orders and must add more orders when the
market moves, leaving a gap between the current
price and his best price.
Moreover, exchanges generally restrict limit
prices to even fractions and use first come, first
servedas a way of allocating orders at the same
price. Thus, a traderwho is scaling his limit orders
enters extra orders far in advance so he has a good
position in the queue at each price. When he
finishes trading, he cancels his extra orders.
In a frictionless market with free cancellation
of conventional limit orders, there can be no equilibrium. Traders try to put in all possible orders
they might ever want to use, so they will be at the
head of the queue if they do want to use an order.
Only one person, however, can actually be at the
head of each queue.
To avoid the costs of single-price limit orders
and the complications of scaling and to allow
equilibriumin a frictionless world, exchanges can
offerindexedlimitorders.An indexed limit orderhas
a limit price that is continually adjusted to market
conditions. In effect, an indexed limit order to buy
becomes an order to buy at the bid side of the
market, and an indexed limit order to sell becomes
an order to sell at the asked side of the market.7
Restrictingtrade prices to even fractionsworsens the problem of allocating by queue, so I
imagine that indexed limit orders trade at decimal
prices. To reduce the incentive to put orders in
early, I imagine that exchanges treat all similar
orders equally. They pay no attention to an order's
entry time.
Some traders who use indexed limit orders
want to trade faster than others, so exchanges offer
indexed limit orders that vary in urgency. An
urgent order executes faster and costs more than
the typical order. Urgency takes the place of time
priority in allocating orders at a single price, but
even the most urgent orders share all executions
with other orders. When allocating scarce resources, using cost is almost always more efficient
than using waiting time in a queue.
Indexed limit orders seem to dominate conventional limit orders because they take account of
current market conditions and because they eliminate the incentive to put orders in early. In equilibrium, I expect all traders to use indexed limit
orders at varying levels of urgency.
A news trader is likely to be less patient than
a nice traderbecause he wants to trade before his
news becomes public. Thus, urgent orders come

26

more from news traders than from nice traders,

and orders that execute slowly but at low cost
come more from nice traders.
Because any limit order may come from a
news trader,arrivalof an order moves the price:A
buy limit order moves it up, and a sell limit order
moves it down. Because news traders make up a
larger share of urgent orders, arrivalof an urgent
ordermoves the price more than arrivalof a typical
order.
An exchange can distinguish among more and
less urgent orders only when it penalizes limit
order cancellation.With free cancellation,a trader
can enter a very large limit orderwith low urgency
and then cancel when he has the shares he wants.
He has fast execution at low cost, thus avoiding
the penalty for urgency.
Similarly, an order with constant urgency
must have a fractionalexpected execution rate that
does not depend on how much has executed so
far. If the expected execution rate in shares is constant, the order's effective urgency rises as it executes, so its expected execution cost must rise too.
Because a trader is free to break up his order
into small pieces or to join his order with other
traders'orders before entering it, the price moves
caused by pieces of an order must add up to the
price move caused by the full order. Roughly, this
fact means that entry of a limit order at a given
level of urgency causes a price move proportional
to order size.
When all tradersuse indexed limit orders, we
can define market depth for each level of urgency
as the number of shares it takes to move the price
one small unit. (Earlier, when considering the
possibility that traders use market orders, we defined depth in a related but differentway.) Depth
is a local property that can depend on market
conditions, including the amounts of buy and sell
limit orders at various levels of urgency. Buy and
sell depth must be the same. Depth can appear to
depend on order size only through its dependence
on market conditions.
Similarly, a buy limit order and a sell limit
orderwith the same urgency should have the same
effect on price as the net of the two orders. If the
effects are different,a traderwho cares only about
profits will see opportunities.
If we could hold market conditions fixed, the
price impact of a limit order at a given level of
urgency would be proportionalto order size. Local
depth would also be global depth. A 10,000-share
order would move the price ten times as much as
a 1,000-shareorder.

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EXCHANGES
An exchange has indexed limit orders at various
levels of urgency on both sides of the market.
Market depth depends on urgency and market
conditions, including conditions at other exchanges. In fact, entering an order on one exchange changes the price at all exchanges trading
the same security.
The market is shallower for more-urgent orders; market depth approaches zero as urgency
continues to rise. Thus, when new public information arrives in the market, a few small, urgent
orders move the price by almost the full value of
the information.
In setting the depth schedule, an exchange is
acting as a kind of Walrasianauctioneer.It balances
supply and demand for urgency, and more-urgent
orders cost more because they attractmore news
traders. At each level of urgency, the auctioneer
follows the size of the book of limit orders and the
price changes following entry of new orders. He
chooses the speed at which he matches orders so
that the book neither grows nor shrinks, on average. He chooses market depth so that the price
neither rises nor falls, on average, following entry
of a new order.
The exchange matches buy and sell limit orders continuously at the current price. On each
side of the market, the fractionalexecution rate is
higher for more-urgent orders;also, the execution
rate rises as orders build up on both sides of the
market. Because the exchange may have more
orders on one side of the marketthan on the other,
the actual fractional execution rates for orders of
given urgency may differbetween the two sides of
the market.
When a news trader puts in an order, he
moves the price by less than the full value of his
news. His profit depends on the amount he can
execute before his news becomes public and on
how fast other news traders arrive in the market
with the same information.
When a nice trader puts in an order, his
expected trading cost rises with urgency because
more-urgent orders move the price more and because they execute faster, which means the price
has less chance to revert toward its original level.
With fractional execution of limit orders, we
can end up with lots of very small orders. To avoid
this, an exchange can use a system by which small
orders do not participatein every trade. Fora small
order, the fractionalexpected execution rate represents the chance that the order executes in full

rather than the fractionof the order that executes

in each trade.
Similar exchanges can compete by sharing
orders and executions. If the execution speed or
expected cost of trading on an exchange deteriorates, nice traders migrate to a competing exchange, and news traders soon follow. As long as
different exchanges are equally efficient, this process will make all exchanges equally attractive.An
exchange that is more efficientthan its competitors
will attractmore order flow.
An exchange may choose to specialize in certain kinds of orders. As long as it allows both buy
and sell orders of those kinds, such specialization
is consistent with equilibrium. For example, an
exchange can specialize in orders with little urgency. It executes its orders slowly, and its market
is deep. It attractsmostly nice traders, with a few
news traderswhose news has a very long half-life.
A nice traderwho uses such an exchange can
expect only modest losses to news traders, but he
will do just as well by putting a low-urgency order
into a full-serviceexchange. Specializedexchanges
have no particularadvantages in equilibrium.

AN EXAMPLE
OF EQUILIBRIUM
Imagine that limit orders from news traders and
nice tradersarriveat the same rate. All orders from
nice traders have x shares, and news traders use
orders of x shares so they will look like nice
traders. Market depth is such that an order of x
shares moves the price by p. All news has value v.
News (or lack of news in an order from a nice
trader)becomes public at the continuous probability rate A. Orders execute at the continuous fractional rate ,u. All orders are equally urgent because
news traders want to look like nice tradersin this
respect.
A nice traderexpects the price to revert to its
originallevel at rate A. Thus, his expected cost per
share traded, c, is

c=

pelAtie-td +dt

Jo

+ u)
~~~(A

A news trader expects the price to continue to

move until it reflects the full value of his news. He
moves the price by p by entering his order. He
expects it to move by an additional amount, v - p.
Thus, his expected profit per share, a, is

=f

(v

p)e-

At,e-

JLtdt =(v

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27

These equations are approximate because actual

random arrivals of orders on each side of the
market will change the fractional execution rates
on the two sides.
A condition of equilibriumis that news trader
profits must equal nice trader losses. Because all
orders are the same size, a = c. Therefore, based
on the equations above, p = v/2. In other words,
marketdepth must be such that any order causes a
price move of half the value of a piece of news. If
the order is from a news trader, we expect the
price to continue an equal amount in the same
direction. If it is from a nice trader, we expect the
price to revert to its original level.
The condition that news trader profits equal
nice traderlosses is equivalent, in this case, to the
condition that price moves randomly enough to
eliminate trading profits for those who simply
watch the sequence of trades.

Dears
Dealers have no role in this equilibrium.Traders do not use market orders. If they did use
market orders, limit orders would provide the
market's depth. Exchanges would not need dealers to provide depth.
Exchanges simply match indexed buy and sell
limit orders. All a dealer can do is put in his own
limit orders. If he does this without any special
information, he expects to lose money on his
trades. Marketmaking is unprofitable, so in equilibrium, dealers vanish.

Single-Pce Auctions
Some researcherssuch as Amihud and Mendelsen have suggested a series of single-priceauctions, or batchmarkets,instead of or in addition to
continuous trading.8 In the equilibrium outlined
above, the matches between indexed buy and sell
limit orders seem similar to single-price auctions.
In fact, an exchange that matches its buy and
sell orders at regularintervalsdifferslittle from one
that matches its orders continuously. The people
who care are those who want to use very urgent
orders at odd times, but the marketis very shallow
for orders like that, so omitting them does not
affectthe equilibriummuch. Similarly,whether an
exchange remains open all the time or closes
overnight does not matter much.
Those people who propose single-price auctions seem to imagine that tradersput in schedules
of amounts they are willing to buy or sell at
different prices. Like conventional limit orders,
such schedules are outdated by the time they reach

28

the market. They are also hard to formulatein the

first place. Thus, matching of indexed limit orders
dominates a market of conventional single-price
auctions.
When the marketfor exchanges is frictionless,
periodic single-price auctions have no advantages
over periodic or continuous matching of indexed
limit orders at differentlevels of urgency.

SunshineTrading
A sunshinetradeis an order to buy or sell a
certain number of shares at a set future time at
whatever price suffices to clear the market.9Preannouncing the trade signals that you are a nice
traderand thereby reduces your expected trading
cost. We can think of a sunshine trade as a preannounced indexed limit order that becomes urgent
once it starts to execute.
Why do we need sunshine trades when we
have indexed limit orders?The delay in executing
a limit order with low urgency plays the same role
as the delay in executing a sunshine trade. Indeed,
indexed limit orders dominate sunshine trades
because they execute at a constant expected fractional rate. That means an indexed limit order has
no specific time horizon. Exchangesdo not have to
say what other trades people who use limit orders
can or cannot do. In an anonymous market,restrictions like these are difficultor impossibleto enforce.
If exchanges allow sunshine trades but do not
restrict other trading before the specified time,
such trades lose their role in signaling lack of
information.A person can put in a large sunshine
trade to sell and then move the price using a small
but urgent order to buy just before the time of the
sunshine trade. This action makes the sunshine
trade into a news trade.
In other words, sunshine trades add nothing
to a marketin which exchanges offer indexed limit
orders at low levels of urgency. In an unrestricted
equilibrium,sunshine trades vanish.

BasketTrading
Subrahmanyam and Gorton and Pennacchi
have suggested that traders without information
may try to signal that they have no news by
trading index futures contracts or a whole basket
of securities at once.10 Does this strategy mean
that, in equilibrium,a nice traderfaces better terms
if he is trading a basket of securities than if he is
trading individual securities? I think not. If a
basket trade moves prices less than a collection of
individual trades, then any trader can move the
price without taking a net position. He can simul-

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taneously enter opening orders on many individual securities and a closing basket order, choosing
levels of urgency that cause the opening and
closing orders to execute at the same speed. The
likelihood that the opening orders move prices
more than the closing order should cause a change
in the prices of all the securities and the basket.
Knowing this, the tradercan add in another trade
that makes the whole program profitable.
In equilibrium,the only way to signal that you
have no news is to use an indexed limit orderwith
a very low level of urgency.

CONCLUSIONS
What will exchanges look like when we reach a
competitive equilibrium?I conjecturethat they will

offer noncancelable indexedlimit ordersat different

levels of urgency but will not offer market orders
or conventional limit orders. Buy limit orders will
match sell limit orders at the current price and at
an expected fractional rate that increases with
urgency. Limit order entry will move the price by
an amount that is roughly proportional to order
size and that increases indefinitely as urgency
increases. Thus, larger orders and more-urgent
orders will usually cost more. Dealers will have no
special role and will lose money if they use limit
orders;so they will vanish. Traderswithout special
informationwill use less-urgent limit orders; they
cannot do better by using specialized exchanges,
sunshine trading, or basket trading."

FOOTNOTES
1. SanfordJ. Grossmanand Joseph E. Stiglitz, "Information
and Competitive Price Systems," The AmericanEconomic
Review,vol. 66, no. 2 (May 1976):246-53;and "On the
Impossibility of InformationallyEfficient Markets," The
AmericanEconomicReview,vol. 70, no. 3 (June 1980):393408.
2. Albert Kyle, "ContinuousAuctions and Insider Trading,"
vol. 53, no. 6 (November 1985):1315-35;and
Econometrica,
"On Incentives to Produce PrivateInformationwith Continuous Trading," working paper, Princeton University,
1985.
3. LawrenceR. Glosten and Paul R. Milgrom, "Bid, Ask and
TransactionPrices in a Specialist Market with Heterogeneously Informed Traders,"Journalof FinancialEconomics,
vol. 14, no. 1 (March1985):71-100;and SanfordJ. Grossman and Merton H. Miller, "Liquidityand MarketStructure," TheJournalof Finance,vol. 43, no. 3 Uuly1988):61733.
4. Anat R. Admati and Paul Pfleiderer, "Sunshine Trading
and FinancialMarketEquilibrium,"TheReviewof Financial
Studies,vol. 4, no. 3 (Fall1991):443-81.
5. LawrenceR. Glosten, "Is the ElectronicOpen LimitOrder
Book Inevitable?"The Journalof Finance,vol. 49, no. 4
(September1994):1127-61.
6. LawrenceHarris,"Liquidity,TradingRules, and Electronic
TradingSystems," working paper, Universityof Southern
California,1990.
order.See
7. I have called this type of order a participating
Fischer Black, "Toward a Fully Automated Exchange,"
FinancialAnalystsJournal,vol. 27, no. 4 Uuly/August1971):
28-35 and 44; and "A Fully Computerized Stock Exchange," FinancialAnalystsJournal,vol. 27, no. 6 (November/December1971):24-28and 86-87. Brown and Holden
discuss a relatedordercalled a quoteadjustedlimitorder.See
David P. Brown and Craig W. Holden, "The Design of
LimitOrders,"working paper, IndianaUniversity, 1993.
8. Yakov Amihud and Haim Mendelson, "The Effects of

ComputerBased Tradingon Volatilityand Liquidity,"in

Henry C. Lucas, Jr., and RobertA. Schwartz, eds., Inforfor theSecuritiesMarkets(Homewood, Ill.:
mationTechnology
Dow Jones-Irwin, 1989):59-85.
9. See Admati and Pfleiderer,"Sunshine Trading."
10. AvanidharSubrahmanyam,"A Theoryof Tradingin Stock
Index Futures,"TheReviewof FinancialStudies,vol. 4, no. 1
(Spring1991):17-51;and GaryGortonand George Pennacchi, "SecurityBaskets and Index-LinkedSecurities," The
Journalof Business,vol. 66, no. 1 (January1993):1-28.
11. I am grateful for conversations on these issues and comments on earlier drafts to Yakov Amihud, Gilbert Beebower, George Benston, Donald Collat, Thomas Cooper,
Ian Domowitz, Philip Dybvig, Eugene Fama, Steven Fenster, Kenneth French, James Gammill, Gerard Gennotte,
Sanford Grossman, Lawrence Harris, Gur Huberman,
Dwight Jaffee, Ravi Jagannathan,Robert Jones, Eugene
Kandel, Alan Kraus, Michael Levine, Harry Markowitz,
Merton Miller, Mark Mitchell, Paul Pfleiderer, David
Romer,Jose Scheinkman,Myron Scholes, Alan Schwartz,
RobertSchwartz,ErikSirri,CliffordSmith, Stephen Smith,
Hans Stoll, James Stone, AvanidharSubrahmanyam,Rob
Trevor, Jerold Warner, Mark White, and especially
LawrenceGlosten, Joel Hasbrouck,AlbertKyle, and Rene
Stulz. Thanks also to participants in workshops at the
Anaheim meetings of the American Finance Association,
BaruchCollege, Boston University, ColumbiaUniversity,
Emory University, Harvard University, the Institute for
QuantitativeResearchin Finance, McGillUniversity, New
York University, Princeton University, the Stockholm
School of Economics,the Universityof Californiaat Berkeley, the Universityof Chicago, the Universityof Colorado,
the University of New South Wales, the University of
Pennsylvania, the University of Rochester, and Yale University. Earlierversions of this paper had several different
titles.

Financial Analysts Journal / May-June 1995

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