The Dynamics of Market Intermediation: From Plain Vanilla to Electronic Trading Systems

1. Topic 7 Intermediated Markets

2. The Plain Vanilla Order Drive Market We have thus far considered • The plain vanilla, order driven market • A simple limit order book • Continuous trading and call auction facilities

3. Is Trading Really This Simple?

4. Electronic Order Book Systems Work Well For • Retail order flow • Liquid stocks • Non-stressful conditions But A Plain VanillaElectronic Trading SystemCannot do it All

5. More Structure is Needed!

6. The Need for Intermediation • Emergence of the Modern Markets • Intermediation on the New York Stock Exchange • Intermediation at NASDAQ Read on Your OwnText Pages 217 - 238

7. The Ecology of an Order Driven Market Can Break Down • Free riding • Small and mid-cap stocks • Stressful conditions

8. Stressful Conditions • A bear market • Advent of news • Derivatives expirations • Momentum trading • Daily openings • Arrival of a 300,000 share order

9. Market Maker Operations

10. TraderEx Dealer Screen

11. Market Maker Services • Immediacy • Supplemental liquidity • Price discovery • Animation • Price improvement (pages 258-260)

12. Immediacy • Market maker practices are designed to facilitate the rapid execution of customer orders • However, orders are commonly traded patiently (i.e., without immediacy) • Upstairs negotiation of large block trades • Breaking up large orders for submission over time • Limit orders

13. Market Maker Revenues • Spread • Trading the Order Flow • Commissions

14. Market Maker Costs • Inventory cost: Cost of carrying unbalanced inventory • Information cost: Cost of trading with better informed participant

15. What Makes a Market Maker Successful? • Inventory control • Trading the order flow carefully • Ability to hide/disguise large positions • Knowledge of customers (source of the order flow) is also important in practice • Receiving a large percentage of the order flow

16. Quotes and Inventory Positions

17. Inventory Control in TraderEx • If P* jumps above your offer, your customers will, on net, be buyers and your inventory will fall • As your inventory falls, you raise your bid and offer • The higher bid attracts sellers and the higher offer discourages buyers • What happens to your inventory if your bid is raised above P*? Your inventory is controlled by adjusting your bid and offer relative to the unobserved P*

18. Transparency As a Market Maker, How Transparent Do You Want the Market To Be? After you acquire a large inventory in the process of servicing a customer, you must work off that position "Shares sold to a market maker are still for sale” You do not want your inventory revealed by a trade publication

19. How Market Makers Compete • Knowing their customers • Offering an array of services • Developing customer relationships; this results in • Preferencing • Quote matching • A market spread that is greater than it would be in an order-driven environment

20. Market Maker Preferencing What effect would preferencing have on • The volume of orders you receive? • Your inventory control? • Your profitability? Under which regime would you prefer to operate: • Preferencing, or • Strict price and time priorities?

21. Block Trading

22. The Challenge How do you handle an order to buy half a million shares of a stock that, on average, trades 300,000 shares a day? • Dealer capital • Shop the order • Slice and dice the order and submit the tranches to an electronic platform • Call auction • Block trading facility

23. Costs • Bid-ask spread • Market impact • Opportunity cost • Implementation short fall • Losses due to bad market timing

24. Performance Measure Difficult to measure performance • Need a good benchmark • Do not make assessments on a trade-by-trade basis • TraderEx point score

25. Electronic Intermediaries Dark pools • Crossing network (e.g., Posit, Matchpoint) • Negotiation venue (e.g., Liquidnet) • Order matching system (e.g., Pipeline)

26. Dark Pools Free Riding On Price Discovery While Offering Quantity Discovery • Institutions keep their orders hidden to control their transaction costs • How do they find each other and trade? • The problem is called Quantity Discovery

27. Shortcomings of Dark Pools • Lack transparency • Low crossing rates • Exclusivity • Sheer numbers

28. TraderEx Block Trading Block Board

29. TraderEx Block Trading • Institutional Orders • Pipeline Order Flow is separated from the Order Book • Price of order execution is determined from the Market (Order Book) • Minimum Order Size Constraints

30. TraderEx Pipeline Orders and Execution • Passive Order – Bid price is below the bid/ask spread midpoint • Active Order – Bid price is above the midpoint • Vice versa for ask price • Market / Limit • Reward for being Aggressive

31. TraderEx Pipeline Colors and Features • Orange : There is a pipeline order for that stock • Orange with Red : You have placed a sell order • Orange with Green : You have placed a buy order • Yellow with Green : You have placed an aggressive buy order and there is a passive sell order • Yellow with Red : You have placed an aggressive sell order and there is a passive buy order

32. TraderEx Pipeline • Take (Hit) the Passive Offer (Bid) • Bid/Ask spread protection Take Bid