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Trading Costs on European Financial Markets

Trading Costs on European Financial Markets . Frank de Jong University of Amsterdam February 1999. Introduction. London’s ``Big Bang’’ liberalization in 1986 increased competition between European financial markets SEAQ has separate market for non-UK stocks SEAQ-International

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Trading Costs on European Financial Markets

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  1. Trading Costs on European Financial Markets Frank de Jong University of Amsterdam February 1999

  2. Introduction • London’s ``Big Bang’’ liberalization in 1986 increased competition between European financial markets • SEAQ has separate market for non-UK stocks • SEAQ-International • many dual listings • trade in ``local’’ currency

  3. SEAQ-International attracted large trading volume (up to 50% in heydays) • mainly large transactions by institutional investors • Possible causes • cheaper i.e. lower cost of trading • market structure: anonymous trading

  4. Quality of financial market • Transaction costs • explicit: fees, taxes • implicit: bid-ask spread • Liquidity • depth • resiliency

  5. DeJong, Nijman, Roell (1995) • Comparison of transaction costs and depth for French equities on local market and SEAQ-I • Major difference in trading system • SEAQ is pure dealership market • Paris Bourse is electronic continuous action

  6. SEAQ International • Multiple market makers for each stock • Dealers issue quotes on trading screens • Quoted bid/ask prices are binding for fairly large size • Bilateral price negotiation (by phone) between customer and dealer possible • Trades not reported to the public

  7. Paris Bourse • Continuous auction, no dealers or specialist • Immediate trade execution by market order • Liquidity provided by public limit order book • Strict price and time priority • exception: hidden orders • Best prices and recent trade data public info • Off-exchange “crosses” possible within the best buy/sell order prices (“fourchette”)

  8. Research question • Which market has the lowest transaction costs? • Take order size into account

  9. Data • Quote and transaction data (SEAQ) and limit + market order data (Paris) • Sample period: 2 months in 1991 • Very good quality data, but • only limit orders at 5 best prices available • hidden orders not observed • reporting time errors for transactions at SEAQ

  10. Trading volume • Paris has about 10 times as many transactions as London • 5000-10,000 vs. 500-1000 • Median trade size in London is much larger • Paris: median transaction value is FF 100,000 • London: FF 1 M • Turnover about equal

  11. Cost of immediate transaction • Quoted spread • London: quoted bid-ask spread • Paris: best prices in limit order book for given size • On average • London: 1-2 % • Paris: depends on (hypothetical) trade size • small trade: 0.15-0.30% • large trade: 0.5-1%

  12. Effective spread • Quoted spread may not be a good indication of actual cost of trading • ignores timing of transaction • negotiation with market maker • hidden orders • Better measure is Effective spread: • actual transaction price - prevailing midquote • average absolute value over all available transactions of given size class

  13. Effective spread (2) • Estimates • London: 1-1.5% • Paris: 0.15-0.45% • Virtually constant over trade size • most large trades occur when market is deep • Even with explicit transaction costs (0.5%), Paris looks cheaper

  14. Realized spread • Trading moves the market, e.g. a buyer-initiated transaction raises the price of subsequent transactions • inventory control effects • signaling effect: asymmetric information • Realized spread: cost of round-trip transaction

  15. Realized spread (2) • How to estimate realized spread? • Roll’s estimator • regression model • for average transaction, estimates similar to effective spread

  16. Realized spread (3) • Size of transaction taken into account • add size to regression and back out implied transaction cost curve • Paris: slight U-shaped curve • London: flat

  17. Conclusion • Competition between exchanges • Transaction costs London higher than in Paris, except for very large orders (but crosses are possible) • Price impact of trades depends on size • DeJong, Nijman, Roell (1996) estimate components of the spread

  18. References • De Jong, F., T. Nijman and A. Roell (1995), A comparison of the cost of trading French shares on the Paris bourse and SEAQ-I, European Economic Review 39, 1277-1301. • De Jong, F., T. Nijman and A. Roell (1996), Price effects of trading and components of the bid-ask spread on the Paris bourse Journal of Empirical Finance 3, 193-213.

  19. Trading Costs on US Equity Markets Frank de Jong University of Amsterdam November 2000

  20. US equity markets • NYSE • oldest market, largest firms (ca. 2000 listed) • hybrid auction / dealership market • “specialist” for each stock • NASDAQ • smaller size stocks (ca. 5000 listed) • many high tech firms • until 1997 pure dealership market

  21. US equity markets (2) • Regional exchanges • Cincinnati, Arizona, Boston,... • Retail brokers

  22. Recent reforms • NYSE reduced tick size to $1/16 in 1997 • lead to drop in quoted and effective spread • but depth at best quotes decreased • seeChordia, Roll and Subrahmanyam (2000) • Market Liquidity and Trading Activity • NASDAQ reforms in 1997 • competition from public limit order book • more transparency of dealer quotes

  23. The NASDAQ controversy • In 1994, two academics, Christie and Schultz, published a paper that shocked NASDAQ • Christie and Schultz noticed “odd-eight” quote avoidance • almost no $1/8 spreads, and few $3/8 • on NYSE, distribution of quoted spreads is more even

  24. Odd eight quote avoidance • So what? Maybe $1/4 is a fair cost of making the market for highly volatile and small cap stocks • Smoking gun: after publication of this study, quoted spread in many NASDAQ issues dropped! • SEC investigation revealed collusion by market makers to avoid odd-eight quotes

  25. NASDAQ market structure • Before 1997, NASDAQ was pure dealership market • limited number of market makers in each stock • Public traded at market makers’ quotes • orders via phone, no automatic order execution • Inter-dealer trading fragmented • via public quotes • via Instinet (inter-dealer broker)

  26. NASDAQ market structure (2) • Bid-ask spread on public screens often wider than on interdealer system • common feature in dealership markets, cf. FX • Bad handling of public limit orders • front running effectively possible • Lack of transparency and competition

  27. NASDAQ market reforms • After odd-eight quote avoidance scandal, SEC pushed for market reforms • Reform 1: competition from public limit order book • public limit order book; price priority • Reform 2: transparency of dealer quotes • best quotes must be made public

  28. NASDAQ market reforms (2) • Reforms implemented in 1997 • Barclay et al. (1999) study effects of reform • substantial decline in quoted spreads • depth remains at reasonable level • overall decline in average trading cost

  29. References • Christie, W., and Paul H. Schultz (1994), Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes? Journal of Finance, 49, 1813-1840 • Barclay, Christie, Harris, Kandel and Schultz (1999), Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks, Journal of Finance,54, 1-34

  30. References (2) • Chordia, T, R. Roll and A. Subrahmanyam, Market Liquidity and Trading Activity, working paper UCLA

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