Markets and Microstructure

1
Markets and Microstructure

• Maureen OHara
• Cornell University
• June 2007

2
The Big Picture

• Markets provide liquidity and price discovery
• Investors care about risk, return and uncertainty
• Microstructure influences the provision and cost
  of liquidity, the risks of price discovery, and
  the resolution of uncertainty

3
My talk today

• My talk today is about the role and design of
  financial markets.
• These issues are particularly relevant for China
  as its markets evolve and play an even greater
  role in development.
• A particular theme that I want to address is that
  the design of the market is fundamental to the
  success of the market. I also want to offer some
  comments on the current stock market bubble and
  how it can be tempered.

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The Role of Markets

• What markets should do
• Allocate capital to firms for investment purposes
• Stock prices should be signals to firms about the
  markets view of their future prospects.
• Provide an investment vehicle for traders
• What markets should not do
• Become a casino for individual looking to
  speculate

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Some themes in microstructure

• Information
• Transactions costs

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Information

• In an efficient market, the price of a security
  should reflect the value of the underlying
  assets.
• Value current value expected future
  opportunities
• More technically, in an efficient market a
  security price follows a martingale.
• No Free Lunch

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How does information get into price?

• Public information - accounting data, news
  stories, company announcements
• Influences all traders behavior
• Private information
• Influences some traders behavior
• Trades may be a signal of private information

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Learning

• If trades can be correlated with new information,
  then market data can be informative
• Preponderance of buy orders signals good
  information
• Preponderance of sell orders signals bad
  information
• Volume may be indicative of existence of new
  information.
• So traders learn from market data and update
  beliefs

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Implication for market design

• Designing markets to facilitate learning fosters
  price discovery.
• When traders have difficulty learning, then
  assets appear riskier and uninformed traders
  demand less. This can slow the adjustment of
  prices to new information and increase the cost
  of capital for companies

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Markets also provide liquidity to traders

• Buyers and sellers do not always arrive
  simultaneously the time dimension of trading
• Quantity demanded may not instantaneously equal
  quantity supplied the size dimension
• Ease of trading may be periodic buyers and
  sellers may disappear
• A particular concern in a bubble.

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Liquidity has many dimensions

• Spreads
• Price impact of trades
• Ability to trade large quantities without
  affecting the price
• Ability to trade quickly
• These are all transactions costs of trading.
  Liquid markets have enormous advantages over
  illiquid markets, and liquidity begets more
  liquidity.

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Implication for market design

• Designing markets to foster liquidity lowers the
  cost of trading and increases the return to
  investors
• Greater liquidity may also lower the cost of
  capital for firms.

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Markets can also reduce uncertainty

• Uncertainty is not the same thing as risk
• The distinction between known odds and unknown
  odds
• People prefer situations where the odds are known
  
• the Ellsberg paradox
• When uncertainty is large, traders wont
  participate.

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What causes uncertainty?

• Maybe the company doesnt exist..
• Maybe the seller will take my money and not give
  me the stock
• Maybe the company is lying about its financial
  condition
• Maybe the price is being manipulated by other
  traders

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Implication for market design

• Designing markets to reduce uncertainty can
  induce greater participation in markets.
• More participation facilitates risk sharing and
  lowers the equity risk premium
• More participation creates liquidity and lowers
  transactions costs
• More participation generates greater volume and
  exchanges make more money

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Goals of market design

• Designing markets to facilitate learning fosters
  price discovery.
• Designing markets to foster liquidity lowers the
  cost of trading and increases the return to
  investors
• Designing markets to reduce uncertainty can
  induce greater participation in markets.
• Designing markets to reduce gambling motives can
  improve stability.
• What does the optimal microstructure look like?

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What market features facilitate learning and
price discovery?

• Transparency of trades and quotes
• Ability to short sell
• Timely market data volume, depths, etc.
• Derivative markets

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What market features facilitate liquidity?

• Lower fees and access charges
• Tick size issues
• Institutional investor presence
• Designated market makers (particularly for SMEs)
• Periodic call markets
• Efficient trading systems
• Non-fragmented order flow or extremely good
  market linkages

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What market features reduce uncertainty?

• Listing requirements higher for SMEs
• Accounting standards and corporate governance
  rules
• Delisting protocols
• Trade monitoring
• Trading halts, circuit breakers
• Insider trading rules
• Best execution requirements
• Clearing and settlement rules

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What market features reduce gambling?

• Wealth limits on investors
• Super margin requirements?
• Greater regulation to prevent manipulation,
  insider trading
• Allow short selling
• Greater institutional presence
• Generally helped by the allowing futures and
  other hedging products
• Price limits
• Capital gains taxes for short term trading

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Bubble problems

• Trees do not grow to the sky
• Stock prices will fall (probably dramatically)
  because they are no longer tied to economic
  fundamentals
• Allowing individuals access to foreign
  investments would allow some of the excess demand
  to dissipate
• Raising interest rates would also provide some
  alternatives, but this raises other issues
• Stamp taxes are not generally a good idea .
• Cross-holdings of stocks by other companies,
  borrowing by investors on other assets, and
  scaring institutions from the market result in
  irrational pricing

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The outlook for China

• Chinese markets are rapidly developing, but the
  microstructure must catch up.
• Very real risk that a bubble is developing that
  will cause damage to both investors and the
  market
• Still largely a retail market, but greater
  participation by institutions would create more
  liquidity and more stability for stocks.
• Greater investor protection is needed.
• The important role of short selling.
• Need to develop markets, products for hedging and
  risk reduction.

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The Role of Microstructure Research

• Microstructure research can evaluate the
  performance of the market
• Determine its efficiency and liquidity
• Investigate the behavior of alternative market
  structures and suggest new market initiatives.
• Predicting the impact of introducing stock index
  futures
• Suggest trading strategies and ways to minimize
  trading costs.
• Highlight problems and potential abuses in
  markets
• Nasdaq price fixing came to light from research

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Conclusions

• I hope my book will encourage new and important
  research into the microstructure of the Chinese
  markets.
• Thank you