Market Microstructure Daniel Sungyeon Kim Lecture 05

1. Market MicrostructureDaniel Sungyeon KimLecture 05

2. Order-driven Markets Order Precedence Q: What are order precedence rules?

3. More on Order Precedence Q: Why use any rule other than price priority?

4. More on Order Precedence Before 1997, the tick size was wide = $1/8 = 12.5 cents From 2001 forward, the tick size has been narrow = 1 cent Q: Are secondary order precedence rules more important with a wide tick size or a narrow tick size?

5. Size priority • Explanation: • All types of products have segments (soft drinks: regular vs. diet; caffeine vs. no caffeine, etc.) • Providing better treatment of large institutional trades attracts that segment • NYSE emphasizes serving big orders from institutional traders • National Exchange services third market dealers • Electronic Communication Networks (ECNs) service day traders • Etc.

6. More on Order Precedence • Q: What is a uniform pricing rule? • Q: What is a discriminatory pricing rule?

10. Angel, Harris, and Spatt Executive summary highlights: Shift from “human-intermediated markets” (floor or phone) to “computer-intermediated markets” (electronic) Rise of new trading platforms with different bus. models Rise of high-frequency traders and algorithmic trading Growth in trading volume Decline in spreads and commissions Smoothly handled the volatility and volume of the 2008 financial crisis Cost of trading is low in the US compared to the rest of the world

12. Equity Share Volume What do we see?

18. Median S&P 500 Spread Downward trend in spreads for most active stocks Majority of stocks trade at a one-cent spread!

20. Median Russell 2000 Spread Downward trend has not been uniform for less active stocks

22. VIX Index of Volatility Shows short-lived volatility events: 2008 Financial crisis 2003 Run up to Iraq war

24. Median S&P 500 and Russell 2000 Spread / VIX Spreads are partially driven by volatility VIX is measure of volatility Spread / VIX removes the impact of volatility  can see a downward trend once volatility is removed

26. Median Displayed Depth What do we see here? Doubled in the last 5 years

29. Commissions What has happened to commissions?

32. Trade Size Why is the trade size dropping? Large trades are being cut up into smaller trades to reduce the cost

34. Average Quotes per Minute More quotes per minute due to: More volume  more quote updates as depth gets depleted or replenished Decrease in trade size: 10,000 shares desired divided into 5 orders of 2,000 shares each Q: Why would there be a spike in number of quotes during the financial crisis?

36. Market Order Execution Speed NYSE Floor Trade = 20 seconds NYSE Electronic Trade = 1 second NASDAQ Telephone Trade = 10 seconds NASDAQ Electronic Trade = 1 second Increase in execution speed as trading shifts from floor/telephone to electronic

38. Cancellation / Execution Ratio This refers to non-marketable limit orders [market orders or marketable limits get executed immediately, so no chance to cancel them] New info and/or prices change  Cancel your limit order and resubmit at an update price More quotes per minute  more cancels per execution

40. NYSE-listed Market Share Regulation NMS in 2005 freed electronic trading platforms to compete with NYSE It requires an exchange to reroute an order to an electronic exchange (“fast market”) that offers a better price, but the exchange can go ahead and execute a trade while ignoring a potential better price on a floor-based exchange (“slow market”) Allows customers to choose speed over a potential better price  key that ignited massive competition by electronic exchanges “Other” category includes internalization and dark pool trades

42. NASDAQ-listed Market Shares NASDAQ historically replied on Dealers and telephone trades 1989 added SOES to autoex on Dealers 2002 added SuperMontage which allowed autoex of market order and limit order = “matching” 2005 acquired ECNs: iNet and Brute

44. Hendershott & Moulton • Background: in2000 NYSE added Automatic execution (“Direct+”) = true electronic trading, but several restrictions: • Max order size = 1,099 shares • Only marketable limit orders • 30 second rule for repeat executions = 30 second waiting time from one order to the next • Limited toexecution at best bid or ask  not allowed to “walk up the book”

45. NYSE “Hybrid Market” Q: How did Hybrid Market expand automatic execution?

46. More on NYSE “Hybrid” • Adding “Liquidity Replenishment Points” = 10 cents apart • An order can walk up the limit order book, but stops at liquidity replenishment point • Automatic execution  30.07, 30.08, 30.09  stops at 30.10 – only floor trading allowed • NYSE is deliberately slowing down the trading process to allow participants to replenish the limit order book

47. : Impact of Hybrid

48. Speed Q: What do we see in Figure 2?

49. Floor Activity vs. Hybrid Activation

50. Floor Activity vs. Hybrid Activation Q: What do we see in Figure 3?