Markets and Microstructure

1. Markets and Microstructure Maureen O’Hara Cornell University June 2007

2. The Big Picture Markets provide liquidity and price discovery Investors care about risk, return and uncertainty Microstructure influences the provision and cost of liquidity, the risks of price discovery, and the resolution of uncertainty

3. My talk today My talk today is about the role and design of financial markets. These issues are particularly relevant for China as its markets evolve and play an even greater role in development. A particular theme that I want to address is that the design of the market is fundamental to the success of the market. I also want to offer some comments on the current stock market “bubble” and how it can be tempered.

4. The Role of Markets • What markets should do • Allocate capital to firms for investment purposes • Stock prices should be signals to firms about the markets view of their future prospects. • Provide an investment vehicle for traders • What markets should not do • Become a “casino” for individual looking to speculate

5. Some themes in microstructure • Information • Transactions costs

6. Information • In an efficient market, the price of a security should reflect the value of the underlying assets. • Value = current value + expected future opportunities • More technically, in an efficient market a security price follows a martingale. “No Free Lunch”

7. How does information get into price? • Public information - accounting data, news stories, company announcements • Influences all traders’ behavior • Private information • Influences some traders’ behavior Trades may be a signal of private information

8. Learning • If trades can be correlated with new information, then market data can be informative • Preponderance of buy orders signals good information • Preponderance of sell orders signals bad information • Volume may be indicative of existence of new information. • So traders learn from market data and update beliefs

9. Implication for market design • Designing markets to facilitate learning fosters price discovery. • When traders have difficulty learning, then assets appear riskier and uninformed traders demand less. This can slow the adjustment of prices to new information and increase the cost of capital for companies

10. Markets also provide liquidity to traders • Buyers and sellers do not always arrive simultaneously – the time dimension of trading • Quantity demanded may not instantaneously equal quantity supplied – the size dimension • Ease of trading may be periodic – buyers and sellers may disappear • A particular concern in a bubble.

11. Liquidity has many dimensions • Spreads • Price impact of trades • Ability to trade large quantities without affecting the price • Ability to trade quickly These are all transactions costs of trading. Liquid markets have enormous advantages over illiquid markets, and liquidity begets more liquidity.

12. Implication for market design Designing markets to foster liquidity lowers the cost of trading and increases the return to investors Greater liquidity may also lower the cost of capital for firms.

13. Markets can also reduce uncertainty • Uncertainty is not the same thing as risk • The distinction between known odds and unknown odds • People prefer situations where the odds are known – the Ellsberg paradox When uncertainty is large, traders won’t participate.

14. What causes uncertainty? • Maybe the company doesn’t exist….. • Maybe the seller will take my money and not give me the stock • Maybe the company is lying about its financial condition… • Maybe the price is being manipulated by other traders

15. Implication for market design • Designing markets to reduce uncertainty can induce greater participation in markets. • More participation facilitates risk sharing and lowers the equity risk premium • More participation creates liquidity and lowers transactions costs • More participation generates greater volume and exchanges make more money

16. Goals of market design • Designing markets to facilitate learning fosters price discovery. • Designing markets to foster liquidity lowers the cost of trading and increases the return to investors • Designing markets to reduce uncertainty can induce greater participation in markets. • Designing markets to reduce gambling motives can improve stability. What does the optimal microstructure look like?

17. What market features facilitate learning and price discovery? • Transparency of trades and quotes • Ability to short sell • Timely market data – volume, depths, etc. • Derivative markets

18. What market features facilitate liquidity? • Lower fees and access charges • Tick size issues • Institutional investor presence • Designated market makers (particularly for SMEs) • Periodic call markets • Efficient trading systems • Non-fragmented order flow or extremely good market linkages

19. What market features reduce uncertainty? • Listing requirements – higher for SMEs • Accounting standards and corporate governance rules • Delisting protocols • Trade monitoring • Trading halts, circuit breakers • Insider trading rules • Best execution requirements • Clearing and settlement rules

20. What market features reduce “gambling”? • Wealth limits on investors • Super margin requirements? • Greater regulation to prevent manipulation, insider trading • Allow short selling • Greater institutional presence • Generally helped by the allowing futures and other hedging products • Price limits • Capital gains taxes for short term trading

21. Bubble problems • Trees do not grow to the sky • Stock prices will fall (probably dramatically) because they are no longer tied to economic fundamentals • Allowing individuals access to foreign investments would allow some of the excess demand to dissipate • Raising interest rates would also provide some alternatives, but this raises other issues • Stamp taxes are not generally a good idea . • Cross-holdings of stocks by other companies, borrowing by investors on other assets, and scaring institutions from the market result in irrational pricing

22. The outlook for China • Chinese markets are rapidly developing, but the microstructure must catch up. • Very real risk that a bubble is developing that will cause damage to both investors and the market • Still largely a retail market, but greater participation by institutions would create more liquidity and more stability for stocks. • Greater investor protection is needed. • The important role of short selling. • Need to develop markets, products for hedging and risk reduction.

23. The Role of Microstructure Research • Microstructure research can evaluate the performance of the market • Determine its efficiency and liquidity • Investigate the behavior of alternative market structures and suggest new market initiatives. • Predicting the impact of introducing stock index futures • Suggest trading strategies and ways to minimize trading costs. • Highlight problems and potential abuses in markets • Nasdaq price fixing came to light from research

24. Conclusions • I hope my book will encourage new and important research into the microstructure of the Chinese markets. • Thank you