How Securities Are Traded

1. How Securities Are Traded P.V. Viswanath For a First Course in INvestments

2. Learning Goals • What are the different asset classes? • Why is it important to separate them by asset class? • What distinguishes the various asset classes? • Why are indices important and how are they constructed?

3. Types of Markets • Target audience • Public Offering • Private Placement • Degree of Familiarity with Security • Initial Public Offering • Seasoned Equity Offerings • Novelty of the Security • Primary Markets • Secondary Markets • Why do we make these kinds of distinctions? Each typology says something about the issues involved.

4. Types of Markets: Nature of Trading • Direct Search Markets (New Market in non-listed securities; WSJ/NY Times article) • Brokered Markets • Dealer Markets • Auction Markets • Order-Driven Market • Bid-Driven Market

5. Types of Orders • Market Orders • Price-Contingent Orders  

6. Trading Mechanisms Used in the US • Dealer Markets • ECNs • Specialist Markets – obligation to maintain a fair and orderly market

7. Trading Costs • Broker Commissions • Bid-Ask Spread (Implicit cost) • Liquidity Cost • Quality of Execution (if there’s a wait, then a worse price may be obtained) (Effective Bid-Ask Spread) • Margin Cost

8. The Bid-Ask Spread • The bid-ask spread is the price that impatient traders pay for immediacy. The spread is the compensation that dealers and limit order traders receive for offering immediacy. • Traders consider the spread when deciding whether to submit limit orders or market orders. When the spread is wide, immediacy is expensive, market order executions are costly, and limit order submission strategies are attractive. • The spread is also the most important factor that dealers consider when deciding whether or not to offer liquidity in a market. If the spread is too narrow, dealing may not be profitable.

9. Components of the Bid-Ask Spread • Transaction cost spread component – that part of the bid/ask spread that compensates dealers for their normal costs of doing business. These include financing costs for their inventories, wages for staff, exchange membership dues, expenditures for telecommunications, research, trading system development, clearing and settlement, accounting, office space, utilities, etc. • The adverse selection spread component is the part of the bid/ask spread that compensates dealers for the losses they suffer when trading with well-informed traders. This component allows dealers to earn from uninformed traders what they lose to informed traders.

10. A model of the bid-ask spread • The dealer first uses all information currently available to her to estimate the asset value. This estimate V0 is the basis for her bid and ask quotes. • Using this basis, she estimates the asset value, assuming that the next trader is a buyer (V0B) or a seller (V0S). For example, if the next trader is a buyer, then the chances are (e.g. if the buyer is informed), that the true value V0 is higher. Taking the prob of an informed buyer, the dealer comes up with V0B. And similarly for V0S . • She obtains her ask price by adding half of the transaction cost spread component to her value estimate for a buyer. She likewise obtains her bid price by subtracting half of the transaction cost spared component from her value estimate for a seller.

11. A model of the bid-ask spread

12. Model of the Bid-Ask Spread • When the next trader arrives, the dealer learns whether she wants to buy or sell. If the dealer learns nothing more about the trader or about values, other than that the new trader is a buyer or a seller, then the dealer’s new unconditional value estimate will be the appropriate previous conditional value estimate. The bid and the ask will both rise by half of the adverse selection component.

13. Bid-Ask Spread in Order Driven Markets • The bid-ask spread will be non-zero even in order driven markets. • Trading costs/commissions are likely to be higher for limit traders than for market traders because they are more demanding of the exchange’s and the broker’s resources. Suppose commissions for limit orders are l per round trip and m for market orders. • Then assuming that considering that limit traders make the bid-ask spread and market traders pay it, and considering that any trader can either put in a limit or market order and so, in equilibrium, would be indifferent between the two, it must be the case that the net costs for the two types of trades are equal. • Hence l-s = s+m, or s = (l-m)/2 • That is, the bid-ask spread (i.e. the difference between the highest limit buy price and the lowest limit sell price – the price at which limit traders are willing to sell) will be non-zero.

14. Bid-Ask Spread • However, limit orders are not guaranteed to execute. • Also, they provide liquidity and can be picked off by better informed traders, as discussed above. • Hence the bid-ask spread spreadwill be greater, • the greater the spread between limit order commissions and market order commissions, • the greater the cost of canceling and resubmitting limit orders • the more volatile underlying true asset values are (the greater the volatility of true values, the greater the value of the timing option granted by limit traders) • the greater the information asymmetry.

15. Buying on Margin

16. Short Sales

17. Regulation • Securities Act of 1933 • Securities Exchange Act of 1934 – establishes the SEC • Commodity Futures Trading Commission • Securities Investor Protection Act of 1970 • FINRA (Financial Industry Regulatory Authority) – non-governmental self-regulation body • Sarbanes-Oxley Act • Insider Trading regulations – recent investigations of the SEC