Chapter7 Market Microstructure

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Chapter7 Market Microstructure
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1. Introduction

• What is market microstructure?
• study of the process and outcomes of exchanging
  assets under explicit trading rules
• analysis of how specific trading mechanisms
  affect the price formation process.
• Trading mechanism set of rules governing
  the exchange of financial assets (stocks,
  derivatives) or foreign currencies in a market.
• ? specific intermediary, centralized location
  or electronic board, orders submitted,...

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1. Introduction

• Why do we need market microstructure?
• Tries to answer how prices are formed in the
  economy!!!!
• Two different lines of thought in the past
• The trading mechanism has no relevance at all for
  the determination of the equilibrium price
  (Rational Expectation Literature),
• The trading mechanism is relevant (Walrasian
  Auctioneer).

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1. Introduction

• Rational Expectation Literature
• Properties of the equilibrium price are
  relevant,
• Equilibrium price is determined such that the
  supply and demand are equal.
• Walrasian Auctioneer
• (a) Each trader submits his demand to the
  auctioneer.
• (b) Auctioneer announces a potential price and
  traders determine their optimal demand at that
  price.
• (c) An equilibrium prevails where each trader
  submits his optimal order at the equilibrium
  price and at that price the quantity supplied is
  equal to the quantity demanded.

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1. Introduction

• ? Market Microstructure will enhance our
  ability to understand both the returns to
  financial assets and the process by which markets
  become efficient.
• Application
• regulation of markets
• design and formulation of new trading
  mechanisms (proliferation of new markets and
  exchanges, market crash 1987).

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2. Organization of financial markets

• Market player
• Brokers transmit orders for customers, act as
  conduits for the customers orders. Involved only
  in interdealer transactions (FX market) ? pure
  match makers (connect dealers).
• Dealers trade for their own account or also
  facilitate customer orders (broker/dealer).
• Market makers (specialists) quote price to buy
  or sell. Generally take a position in the
  security ? dealer function.

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2. Organization of financial markets

• Orders
• Orders are instructions that traders give to the
  brokers and exchanges that arrange their trades.
• They specify
• security to be traded,
• how much to trade,
• whether to buy or sell,
• Terms
• They may also specify
• their validity
• their execution time
• whether they can be partially filled or not
• Orders affect the profit from trading,
  transaction costs, and the liquidity.

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2. Organization of financial markets

• Types
• Bid buy order specifying a price (price is
  called bid).
• Offer sell order specifying a price (price is
  called offer or ask).
• Best bid standing buy order that bids the
  highest price bid.
• Best offer standing sell order that has the
  lowest price offer.
• Bid-Ask spread difference between the best offer
  and the best bid.
• Orders giving other traders an opportunity
  to trade offer liquidity.
• Orders making a demand to trade take
  liquidity.

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2. Organization of financial markets

• Market order
• Instruction to trade at the best price currently
  available in the market.
• Fill quickly but sometimes at inferior prices.
• Used by impatient traders and traders who want to
  be certain that they will trade.
• Take liquidity from the market in terms of
  immediacy.
• Market order traders pay the spread,
• Execution price uncertainty.
• Market orders fix the quantity to be traded but
  some uncertainty for the execution price.

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2. Organization of financial markets

• Limit order
• Instruction to trade at the best price currently
  available in the market without violating a limit
  price condition.
• For a limit buy order, the limit price specifies
  a maximum price.
• For a limit sell order, the limit price specifies
  a minimum price.
• Marketable limit orders orders that can
  immediately execute when submitted (limit price
  of a buy order is at or above the best offer).
• At the market limit orders limit buy orders
  standing at the best bid and limit sell orders
  standing at the best offer.
• Behind the market limit orders limit orders
  standing behind the best bid or offer.

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2. Organization of financial markets
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2. Organization of financial markets
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2. Organization of financial markets

• Standing Limit orders are trading options that
  offer liquidity
• Sell limit orders are call options and buy limit
  orders are put options and the strike prices are
  the limit prices.
• Limit orders are not option contracts (not sold).
• The option value of a limit order is the value of
  the order to other traders. It depends on
• limit price,
• standing period,
• price volatility.

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2. Organization of financial markets

• Compensation for offering liquidity
• Upon execution, the trader receives a better
  price than when submitting a market order.
• Standing limit orders await the movement of
  prices to become active.
• Risk implied by using standing limit orders
• Traders using standing limit orders face two
  risks
• risk execution uncertainty (aggressive orders),
• risk ex-post regret (chase the price).
• Limit orders control the price paid or received
  but the investor has no way of knowing when and
  if the order will be filled.

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2. Organization of financial markets
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2. Organization of financial markets

• Stop order
• Specifies a price and a quantity.
• Activates when the price of the stock reaches or
  passes through a predetermined limit (stop
  price). When the trade takes place the order
  becomes a market order (conditional market
  order).
• Mainly used on market orders and few on limit
  orders.
• Used in order to sell when the market is falling
  or to buy when the market is rising.
• Difference between stop orders and limit orders
• Lies in their relation with respect to the order
  flow.

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2. Organization of financial markets

• Stop loss orders transact when the market is
  falling and they are sell orders ? they take
  liquidity from the market (must be accommodated
  ?provide impetus to any downward movement).
• Limit orders trade on the opposite side of the
  market. If the market is rising, the upward
  movement triggers limit orders to sell ? provide
  liquidity.
• Other orders
• Short sale sell the quantity you do not own (the
  trader expects the share to decline in value).

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2. Organization of financial markets

• Ordre au prix du marché order to trade the
  security at the market price and if at that price
  some of the quantity remains unexecuted, this
  part transforms to a limit order. The limit price
  is the price at which some of the order was
  executed.
• Market-If-Touched order order to trade a
  security at the market if the market touches some
  preset price (orders to buy when the market is
  falling and orders to sell when the market is
  rising).
• Orders specifying validity and expiration
  instructions Day orders, Good-till-cancel
  orders, Good-until orders, Immediate-or-cancel
  orders.

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• Orders specifying a quantity instruction
  All-or-none orders, minimum-or-none orders.
• Market structures
• We focus on two levels trading sessions level
  and on the execution system.
• Trading sessions Continuous market sessions or
  call market sessions
• Execution system quote-driven markets
• order-driven markets
• brokered markets
• Trading sessions
• Continuous markets

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2. Organization of financial markets

• Traders may trade anytime while the market is
  open. Traders may continuously attempt to arrange
  their trades.
• Call markets
• Traders may trade in call markets only when the
  market is called.
• You may have all securities called at the same
  time or only some. The market may be called
  several times per day.
• Used to open sessions in continuous markets
  (Bourse de Paris,...). Also used for less active
  securities, bonds,....
• Batch execution system arrange all trades at the
  same time. We may have a single price auction or
  a discriminatory price auction.

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2. Organization of financial markets

• Arizona Stock Exchange is organized as a batch
  execution system with single price auction.
• Bilateral trading traders can arrange their
  trades among themselves but only when the market
  is called..
• calls focus the attention of traders on the same
  security at the same time.
• continuous traders can arrange their trades
  whenever they want.
• Execution systems
• Quote-Driven Dealer Markets
• In pure quote-driven markets, dealers participate
  in every trade.
• Dealers supply all the liquidity and quote the
  prices at which they will buy and sell.
• Examples NASDAQ, London International Stock
  Exchange (SEAQ),....

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2. Organization of financial markets

• Buy orders decrease the inventory position of the
  dealer whereas sell orders increase his inventory
  position.
• Bid-ask spreads placement reflects the inventory
  position (incentive theory)
• When dealers inventory is low, he sets a high
  bid price.
• When dealers position is large, he sets a low
  ask price.
• The dealer manages his inventory with the
  placement of his bid-ask spread.
• Order-Driven Markets
• Buyers and sellers regularly trade with each
  other without the intermediation of dealers.
• Must specify how trades are arranged (trading
  rules)

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2. Organization of financial markets

• order precedence rules match buy orders with
  sell orders (price priority, time priority,...)
• trade price rules determine the trade price
  (single price auction, continuous two-sided
  auctions).
• Comparison Between the Different Execution
  Systems
• Auction all outstanding orders are transacted at
  a single price (periodic and continuous).
• Dealership all outstanding orders are placed
  with individual dealers who execute them at
  preset quoted prices (continuous).
• Fact the Londons dealership market has taken
  volume away from the continental auction markets
  (Paris, Milan, Madrid,...), mainly large
  institutional investors.

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2. Organization of financial markets

• Prices are quicker to adjust to order flow
  information in a centralized market.
• Transaction costs
• Auction market details of all deals are
  immediately publicized on line
• Dealership market (London) transaction prices
  are formed by a dealer before he becomes fully
  aware of his competitors recent order flow. For
  large orders the release of the details may wait
  for five working days.
• The dealers are forced to set spreads that are
  wider on average than in an auction market ? on
  average the auction market is cheaper for the
  liquidity trader than the dealer market.
• The trader has the possibility to hit several
  dealers simultaneously, we may exacerbate the
  effect that the imperfect aggregation of order
  flow information has on average trading costs.

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2. Organization of financial markets

• Empirically no evidence of that but evidences
  that an hybrid system performs better in terms of
  liquidity than would do any pure systems.
• Execution risk riskiness of the transaction
  price
• Dealer market dominates the auction market. In a
  dealers market it is harder to trade
  anonymously.
• The advantage of the floor trading over the other
  systems is the opportunity to observe who trades
  what with whom, how urgently....? the electronic
  trading system does not allow that.
• The dealership market leaves some room for
  bilateral negotiations ? more information ?
  some traders can be identified as being liquidity
  traders reducing their average transaction costs
  ? harms liquidity traders who cannot be
  recognized. But the total cost to the liquidity
  traders decreases.
• Matching orders cannot cross directly in a dealer
  market.

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2. Organization of financial markets

• Public limit order exposure any agent is able
  to submit limit orders.
• The dealership system does not provide facilities
  for the ordinary traders to expose their limit
  orders? impracticable and costly to bypass the
  dealer and find out the existence of a matching
  order.
• In the auction market ordinary traders may either
  trade directly with one another or transact with
  professional intermediaries.

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3. The Bid-Ask Spread

• The prices at which dealers are willing to buy
  and sell are the bid and ask prices.
• The bid-ask spread is the difference between the
  ask price and the bid price. This spread is
  called the quoted spread. It is, then, an
  overestimate of the remuneration of the service
  provided by dealers (liquidity immedaicy). The
  remuneration is large when the spread is wide
  whereas it is small when the spread is narrow.
• The realized spread (true remuneration of
  providing liquidity) is the difference between
  the prices at which dealers actually buy and sell
  their securities.

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3. The Bid-Ask Spread

• We can define three components entering the
  quoted bid-ask spread
• Inventory risk (Transaction cost component or
  Transitory spread component)
• Portfolio balance
• Adverse selection
• Inventory risk
• Inventories are positions that dealers have on
  the securities they trade.
• Target inventories are positions that the dealers
  want to hold.

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3. The Bid-Ask Spread

• For risk averse dealers any difference between
  inventories and target inventories is costly.
  They then require compensation for absorbing
  transitory mismatches in supply and demand over
  time (transitory risk premium).
• The larger the mismatch, the greater the
  compensation required by dealers.
• This risk is called transitory because it can be
  diversified away.

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3. The Bid-Ask Spread

• Dealers may act in order to control their
  inventories. As dealers prices affect other
  traders trading decisions, the placement of
  their bid-ask spread may be used to control their
  inventories.
• When the dealers inventories are below (above)
  their target inventories, they must buy (sell)
  the security.
• Dealers increase their prices (bid and ask) when
  they want to increase their inventory. Higher bid
  prices encourage traders selling to them and
  higher ask prices discourage traders buying from
  them.

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3. The Bid-Ask Spread

• Dealers decrease their prices when they want to
  decrease their inventory. Lower bid prices
  discourage traders selling to them and lower ask
  prices encourage traders buying from them.
• Another option available to dealers is to change
  their quotation sizes (i.e. the quantity
  available at each price). To increase (decrease)
  their inventory, they increase (decrease) the bid
  size and decrease (increase) the ask size.

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3. The Bid-Ask Spread

• Portfolio balance
• Persistent effect this risk cannot be
  diversified away.
• Even after risky positions are spread through the
  economy as a whole, order flows effect on price
  will not disappear completely.
• Adverse selection
• This component is due to the presence in the
  market of traders with private information or
  superior information. They have better
  information than the dealers themselves and the
  dealers have no way to distinguish between a
  better informed trader and an uninformed trader.

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3. The Bid-Ask Spread

• It is always the case that the dealers lose on
  those traders. They buy when the prices will
  increase or when the ask price is below their
  estimates of the asset value given their private
  information. They sell when the prices will
  decrease or when the bid price is above their
  estimates of the asset value given their private
  information.
• Dealers can balance the losses made on informed
  trading with the profits made on uninformed
  trading.
• The greater (lower) the bid-ask spread, the lower
  (greater) are the losses on informed trading and
  the greater (lower) are the profits on uninformed
  trading

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Theoretical Frameworks

• Standard Walrasian models
• The formation of asset price
• pt log price of the risky asset at time t.
• PVt present value of future cash flows.
• vt fundamental or true value
• It the set of full given public information at
  time t.
• Implication of the SWM
• Efficient market
• public info. moves market (martingale process)
• all players share same info. and expectation
  (homogeneity)
• Price clearing mechanism
• Trading process is inconsequential
• No rational bubbles

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• Challenges to the SWM (?bid-ask spreads)
• heterogeneity information, preference
• Representative agent set-up is incorrect
• institutional constraints
• Price quotes by market makers precede orders
• Inventory for liquidity traders
• Incomplete risk sharing for uncertainty
• Price discovery of private info.
• Grossman Stiglitzs REM model (AER, 1980)
• Insights
• Price clears markets and conveys information
• Two paradoxes of ERM
• individuals neglect their own private
  information
• private information can only be acquired at a
  cost.

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• Set-ups
• Perfect competition (implicit auctioneer,
  non-strategic)
• Two risk-averse traders, information asymmetry
  (v??,?) cost
• Single risky asset and single trading period
• Techniques
• Event chart------
• S (V,?) private information signal for V ?
  informed trader
• X1,X2 initial random endowments (same risky
  asset) for two traders (XsXIXU)
• P trading price
• V the value of the risky assets end-of-period
  payoff

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• Described function------
• (1)
• S is normally distributed
• (2)
• Each investor holds the same CARA preference
• (3) (Conjectured
  linear pricing rule)
• Conditions for rational-expectations equilibrium
• (1) expectations of the payoff V are consistent
  with the equilibrium pricing rule
• (2) excess demand equals zero for all random
  variable realizations
• Expectation of the payoff V
• Informed trader (signal)
• Implication weaker signal (?s??)---E.0
  stronger signal (?s?0 )---Var.0

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• Uninformed trader (price)
• Where
• Demand for risky asset
• Informed trader
• Uninformed trader
• Market-clearing price(??,?)

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