Market Structure, Trading, and Liquidity FIN 2340

1. Dr. Michael Pagano, CFA Adapted from Slides by: Dr. Robert Schwartz © 2004 Baruch College and Wayne Wagner President, Plexus Group Market Structure, Trading, and LiquidityFIN 2340

2. Overview of Key Market StructureTopics • Why Study Financial Market Structure? • Overview of Market Structures & Trading Simulation • From Information to Prices • Liquidity Provision in Perfect & Imperfect Markets • Strategic Use of Limit and Market Orders • Market Intermediaries & the Evolution of Securities Markets • Institutional Order Flow • Algorithmic Trading and Technical Analysis • Trading Performance Measurement • Regulation

3. Topics 1 & 2Getting a Grip on Trading • Customers (Investors & Issuers) • Brokers / Dealers • Market Centers (Listings / Order Flow / Data) • Benefits vs. Costs (Net Returns vs. Transaction Costs)

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

5. U.S. Equity Market Centers National Markets: NYSE, Nasdaq, Amex Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia Over-the-Counter Market (OTC) Alternative Markets (ATSs, ECNs), e.g.: INET (part of Nasdaq now) Archipelago (part of NYSE Group now) POSIT (Investment Technology Group) Liquidnet Pipeline The Equity Markets

6. Trading Players • Investors • Asset Exchangers • Bluffers • Uninformed traders • Speculators • Dealers • Brokers • Exchanges

7. Some Main Points to keep in mind • Traders who seek profit create liquidity and price efficiency. • Keep your eye on who has the information. • All profits ultimately must come from uninformed traders. • Comparative advantages and trading rules determine trader profits in the long run.

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

9. 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

10. 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% annual return over: 1, 5, and 10-year horizons? Cost Components

11. Total Cost

12. Commissions

13. Impact

14. Inter-day Delay

15. Getting a Grip on Trading (cont.) • Order Flow & Order Arrival Rates • Trading vs. Investing • Trader Types: Informed / Liquidity / Technical • Trading Simulation: Limit Order Books & Trading “Ecology” • Bid-Ask Spread & Limit vs. Market Orders • Liquidity (Time & Space) & Trading Performance

16. People and institutions who use market services are on the buy-side. Those who provide market services are on the sell-side. Both are customers of exchanges / markets. These sides have nothing to do with whether you are a buyer or seller of a specific security. The Two Sides of the Trading Industry

17. Individuals Corporate pension fund sponsors Charitable trusts Legal trusts Endowments Investment managers Corporate investment funds Insurance reserve funds Governmental funds Buy-Side Players

18. Dealers trade for their own accounts. Day Traders Scalpers “Locals” Brokers trade for other people’s accounts. Retail and institutional Full-service and discount Broker-dealers do both. Specialists Wire houses Sell-Side Players

19. Market Centers provide systems that help traders arrange their trades. Note that market centers and brokers often compete with each other. Clearing houses help settle trades and guarantee that traders will perform (NSCC). Depositories and custodians hold securities (DTC). Sell-Side Trade Facilitators

20. Goal of a Trading System • Bring customer orders together to make trades: • At reasonable cost • In a timely fashion • At reasonable prices • Success depends on quality of a market’s structure: • The systems, rules and protocols that determine how orders are handled and transformed into trades

21. Liquidity Order Flow Informed Technical Trading P* Is there a trend/ pattern? Quotes, Prices, Volume Is p*>offer or p*<bid? What Drives a Market? 3 Sources of Orders Trading Mechanism

22. The Big Problem Enabling Buyers and Sellers, Large and Small, to Find Each Other • Two Dimensions • Place • Time

23. 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

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

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

26. Topics 3 & 4All About Liquidity • Gross vs. Net Investment Returns ($1100 vs. $1067) • Frictionless CAPM vs. Real-world Frictions • Info Types: • Market vs. Fundamental • Public vs. Private vs. Insider • Divergent Expectations and Adaptive Valuations • Liquidity: Depth / Breadth / Resiliency / Speed

27. All About Liquidity (cont.) • Transaction Costs: Explicit vs. Implicit • Explicit: Commissions / Exchange Fees / Taxes • Implicit: • Bid-Ask Spread • Total Trading Cost = Delay + Impact + Opportunity Cost • Illiquidity & Transaction Costs affect: • Price Volatility (via bid-ask “bounce”) • Price Discovery • Quantity Discovery • Reduced portfolio net returns

28. All About Liquidity (cont.) • Market Structure Types: • Continuous Order-Driven • Periodic Order-Driven Call Auctions • Continuous Quote-Driven (aka “Dealer markets”) • Negotiated Markets (e.g., ECN / ATS / block trader) • Hybrid Markets • Random Walk vs. Illiquid Market “Symptoms”: • Serial Return Correlation (Positive vs. Negative) • Time Scaling of Variance (e.g., Variance Ratio analysis) • Serial Cross-Return Correlation

29. What Do the Following Have in Common? Without Gas, Neither Will Run

30. Order Flow is Gas 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”

31. Liquidity 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).

32. Price & Quantity Discovery The most important objective of any market is to foster accurate price and quantity discovery Much demand is latent – participants do not readily reveal their desires to buy or to sell Traders instinctively know the price discovery problem. That is why technical analysis is widely used

33. Price Discovery is Difficult Because Investors Cannot assess share values with precision Have divergent expectations Have adaptive valuations Do analysts ever agree?

34. Difficulty of Assessing Share Valuations With Precision Can a stock analyst say with precision that the expected growth rate for XYZ is: • 7.00%, not • 7.55%?

35. Analyst Evaluation of XYZ Dividend one year from now = $1.35 Appropriate cost of eq. cap. = 10% (1) Growth rate (g) = 7.00% (2) Growth rate (g) = 7.55% Share price if g =7.00% = $45 Share price if g =7.55% = $55

36. Price Determination V(H) = $55: The Bulls k percent V (L) = $45: The Bears 1-k percent What price(s) will prevail on the market?

37. 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

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

39. Dealer Intermediation Public Seller Dealer Sells 10:50 10:55 11:00 Dealer provision of immediacy brings buyer & seller together Public Buyer Dealer Buys

40. View From a Market Maker’s Desk Dealer Bid Dealer AskCOD 26.00 CAT 26.20DOG 26.00 COD 26.30TUNA 25.90 DOG 26.30CAT 24.80 TUNA 26.30

41. Order Driven Market Best Ask 100 shs @ $20.00 • Last sale $15 Best Bid 200 shs @ $10.00

42. Thin Order Book Best Public Ask 100 shs @ $20.00 • Mkt order: Sell 100 • Sold @ $10 • #*@$%** • Last sale $15 Best Public Bid 200 shs @ $10.00

43. Dealer/Specialist “Makes” the Market Best Public Ask 100 shs @ $20.00 Specialist Ask 100 shs @ $15.05 Specialist Bid 100 shs @ $14.95 • Last sale $15 Best Public Bid 200 shs @ $10.00

44. Public Trades with Dealer Best Public Ask 100 shs @ $20.00 Specialist Ask 100 shs @ $15.05 Specialist Bid 100 shs @ $14.95 • Mkt order: Sell 100 • Sold @ $14.95 •  • Last sale $15 Best Public Bid 200 shs @ $10.00

45. Dealer Is Long 100 Shares Best Public Ask 100 shs @ $20.00 Specialist Ask 100 shs @ $15.05 Specialist Bid 100 shs @ $14.95 $14.90 Best Public Bid 200 shs @ $10.00

46. A Call Auction Public Seller 10:50 10:55 11:00 A meeting point in time can bring multiple buyers & sellers together Public Buyer

47. The Electronic Call Auction • Orders that could otherwise be matched and executed are held for a big, multilateral clearing. • Clearings are held at pre-determined points in time (i.e., once an hour). • All crossing orders are executed at a single price: • Buy orders at that price and higher execute • Sell orders at that price and lower execute

48. The Batching of Customer Orders O Offer • Bid Price 52 O • O 51 • • O 50 • 49 O Question How should these limit orders be integrated to produce a good price? • 48 O • 47 1 2 3 4 5 6 No. Orders

49. • • (1) • (1+2=3) • • • (3+1=4) • • (4+1+5) • • (5+1=6) • Cumulate The Buy Orders • Individual buy order  Cumulated buy orders at the price or better Price 52 51 50 49 48 47 1 2 3 4 5 6 No. Orders

50. O (5) • (4) O (3) • O • O (2) (1) O • • Cumulate The Sell Orders Price 52 51 50 49 • Individual sell order O Cumulative sell orders at the price or better 48 47 1 2 3 4 5 6 Orders