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Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance

Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance Professor of Finance Villanova School of Business May 12, 2011. MBA 8750 – Current Topics Seminar The Current State and Structure of U.S. Financial Markets: Implications from the 2010 “Flash Crash”.

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Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance

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  1. Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance Professor of Finance Villanova School of Business May 12, 2011 MBA 8750 – Current Topics SeminarThe Current State and Structure of U.S. Financial Markets: Implications from the 2010 “Flash Crash”

  2. Overview of Seminar

  3. Is trading this simple? …

  4. or slightly more difficult ??

  5. What Motivates Trading? • New information (unexpected news) • Liquidity needs • Divergent expectations (people agree to disagree) • Technical (noise) trading

  6. Firm Investor IB / CB Firm Investor Buyer Seller Agent Exchange or Market Maker Fundamental Financing Channels Agent

  7. U.S. Equity Market Centers National Markets: NYSE, Nasdaq, BATS, DirectEdge Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia Over-the-Counter Market (OTC) Alternative Markets (ATSs, ECNs, “Dark Pools”), e.g.: INET (ECN part of Nasdaq now) Arca (part of NYSE Euronext now) POSIT (Investment Technology Group) Liquidnet and Pipeline (private block trading networks) Sell-side Dark Pools run by Goldman, Credit Suisse, etc. The Equity Markets

  8. Trading Players • Retail Investors • Institutional Investors • High Frequency Traders (HFTs) • Speculators • Dealers / Market Makers • Brokers • Exchanges • Off-Exchange Trading Systems • Corporate Issuers • Regulators

  9. Major Trading Issues • Liquidity • Informative Prices • Volatility • Transaction Costs • Trading Profits • Net Investment Returns

  10. Commission 5 ¢ (17 bp) Impact 10 ¢ (34 bp) Delay 23 ¢ (77 bp) Missed Trades 9 ¢ (29 bp) • The Iceberg of Transaction Costs Source: Plexus Group, 2003

  11. Total Cost = Commission + Impact (intra-day) + Delay (inter-day) approx. 157 bps (one-way)  314 bps (round-trip!) What is the cumulative impact on a 10% gross annual return over just 1 year? Answer: Net return is only 6.57% (a 34.2%decrease!) Trading Cost Components

  12. Order Driven Market Public Seller 10:50 10:55 11:00 The limit order book brings buyer& seller together Places a Buy Limit Order Limit Order Executes Public Buyer

  13. The Limit Order Book Air Pocket Bid – Ask Spread (10.95 - 11.10) Air Pocket

  14. P* and Best Bid and Offer Quotes P* Ask Bid Day 1 Day 2

  15. Order Flow is “Fuel” For a Market Order Flow = Liquidity An excellent system will not operate if it does not receive Critical Mass Order Flow “Order flow attracts order flow”

  16. Liquidity Main Attributes of a liquid asset • Breadth: orders on the book exist at an array of prices in the close neighborhood above and below the price at which shares are currently trading. • Depth: orders are of large size. • Resiliency: price changes due to temporary order imbalances quickly attract new orders to the market, thereby restoring reasonable share values. • Frequent trading (at high speed).

  17. The Raison d’être of Algorithmic Trading • Dynamic price discovery • The fast speed in which events can occur • Exploit Market inefficiencies to ↓ costs and ↑ profits

  18. The 9/30/2010 CFTC - SEC “Flash Crash” Report

  19. Flash Crash Summary of Events • The events of May 6 can be separated into 5 phases (shown in Figures 1.1 and 1.2 on following slides): • Phase 1:From the market’s open through about 2:32 p.m.,prices were broadly declining across markets, with stock market index products sustaining losses of about 3%. • Phase 2: From about 2:32 p.m. through about 2:41 p.m., the broad markets began to lose more ground, declining another 1-2%. • Phase 3: Between 2:41 p.m. and 2:45:28 p.m., lasting only about four minutes or so,volume spiked upwards and the broad markets plummeteda further 5-6% to reach intra-day lows of 9-10%. • Phase 4: From 2:45 p.m. to about 3:00 p.m., broad market indices recovered while at the same time many individual securities and ETFs experienced extreme price fluctuations and traded in a disorderly fashion atprices as low as one penny or as high as $100,000. • Phase 5: At about 3:00 p.m., prices of most individual securities significantly recovered and trading resumed in a more orderly fashion.

  20. More on the Flash Crash… • STOCK INDEX PRODUCTS: THE E-MINI FUTURES CONTRACT AND “SPY” EXCHANGE TRADED FUND (ETF) • A LOSS OF LIQUIDITY IN THE E-MINI AND “SPY” ETF MARKETS • AUTOMATED EXECUTION OF A LARGE SELL ORDER IN THE E-MINI FUTURES CONTRACT • CROSS-MARKET PROPAGATION (FUTURES TO CASH MARKETS) • LIQUIDITY IN THE INDIVIDUAL STOCKS THAT COMPRISE THE S&P 500 INDEX

  21. Key Graphs from CFTC / SEC Flash Crash Report

  22. Key Graphs from Joint Flash Crash Report (cont.)

  23. Key Graphs from Joint Flash Crash Report (cont.)

  24. Key Graphs from Joint Flash Crash Report (cont.)

  25. Key Graphs from Joint Flash Crash Report (cont.)

  26. Key Graphs from Joint Flash Crash Report (cont.)

  27. Key Graphs from Joint Flash Crash Report (cont.)

  28. HFT and Market Stability (limit up/dn; breakers) Reg NMS and Market Fragmentation Level Playing Field: NYSE, Nasdaq, ECNs, ATS Fairness for Retail vs. Institutional Investors Insider Trading and Increased Surveillance Mergers of For-Profit Exchanges / ATS firms Impact on Corporate Issuers (e.g., WACC, prices) Key Regulatory Topics

  29. Homework Assignment Written deliverable (reflection paper on pre-work and in-class activities) to be graded by Prof. Pagano. The assignment will be to discuss the concepts and experiences from this class that were most salient to your own personal investments and / or your firm’s situation. Please limit your response to 350 to 500 words (i.e., 1-2 pages, double-spaced with 12 point font size).

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