Teaching and Exchanges Eugene Kandel

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Teaching and ExchangesEugene Kandel

• 2002

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Lecture 1

• Introduction

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Greetings

• Who am I?
• Who are you?
• Why are we here?
• What will we do?

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Administration

• Lectures.
• Readings.
• Independent study.
• Grades will be based on an exam (30) and the
  seminar paper.
• Book Lawrence Harris, Trading and Exchanges,
  Oxford Press.

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Objectives

• Learn about markets.
• Understand theoretical issues involved.
• Appreciate the complexity of exchange design, and
  the importance of details.
• Make you a better investor, or an analyst.
• Not necessarily to train you as a trader.

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We will examine

• Why do people trade, and how they do it
• What do markets/exchanges add to society
• Which market characteristics appeal to investors
• Why are markets organized this way
• The recent changes in market design
• The role of public policy.

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Who sets prices?

• New and used car markets
• Buyers and sellers may not know about each other
• Sellers may have informational advantage
• Sellers and buyers may not know the true price
• Sellers and buyers arrive at different times.

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Back to Financial Markets

• Problems with CAPM-type world
• Information incompleteness and asymmetry
• Price discovery
• Demand for and supply of liquidity.
• Markets and institutions arise to address these
  problems. However, these activities are costly,
  and various risks remain!

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Transaction costs

• CAPM with transaction cost
• Nobody holds market portfolio
• Idiosyncratic risk
• Portfolio imbalances
• Higher required return.
• Transaction cost is only one aspect
• Liquidity risk
• Price deviation risk.

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Proceed...

• Introduce terminology.
• Classify markets.
• Discuss important concepts by first
  experimenting, and then formalizing.
• Study cases of several markets.
• If possible, visit a trading room.

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Lecture 2

• Terminology and Classifications

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Terminology

• Markets
• Market participants
• Orders
• Quotes
• Other.

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Classifications of market types

• Primary vs. Secondary.
• Continuous vs. Call (Trading Rounds).
• Single auction vs. Double auction.
• Quote driven vs. Order driven.
• Electronic / Open Outcry / Negotiated
• Levels of transparency.

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Overview of markets

• Bond Markets (US, TASE)
• FX - spot
• Futures (Chicago, Europe)
• Derivatives (Chicago, Interbank, TASE)

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Market Participants

• Trader / Investor
• Informed trader
• Liquidity / Noise trader
• Broker
• Dealer
• Market Maker
• Specialist / Floor traders.

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Orders

• Limit order
• Limit order book (LOB)
• Market order
• Marketable limit order
• ATC and ATO.
• Other orders.

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Quotes

• Bid and Ask (Offer) price
• Depth (quantity)
• Dealer quote
• Inside quote
• Spread dealer and inside.

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Misc.

• Trading session
• Trading procedures
• Price and Time priority
• Volume
• Volatility
• NBBO
• Execution quality / Price improvement.

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Classifications of securities

• Stocks/equities
• Bonds
• Commercial paper
• FX - spot
• Futures - commodities, currencies, indices
• Derivatives.

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Important features

• Price levels
• Volume
• Sensitivity to news
• Magnitude of potential news
• Degree of private information
• Competition among trading venues.

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Brokers

• Verify creditworthiness - buffer.
• Provide bundled services.
• Allow access to markets.
• Provide information, but face competition.
• Find liquidity and match trades - compete with
  markets (ECNs).

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Exercise

• Classify two of the following exchanges,
  according to criteria above, using information
  from the Web
• NYSE
• Nasdaq
• London Stock Exchange
• Paris Bourse
• Deutsche Bourse
• Tokyo Stock Exchange
• Toronto Stock Exchange.

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Proceed

• We formulate four theoretical models underlying
  the main issues in Microstructure.
• Dealer Market
• Inventory model
• Asymmetric information model
• Auction market
• Call auction
• LOB.

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Lecture 3

• Dealer Markets Inventory Model

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Questions

• Dealer is willing to provide liquidity from his
  inventory what are his considerations?
• Risk aversion?
• Competition?
• Inventory size?
• Trade size?

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Lets play a game

• You are a dealer in a particular security.
• Your inventory, denoted by Y, equals the last 4
  digits of your phone number. If it is even, then
  this is the number of shares you own. If the
  number is odd - then this is the number of shares
  that you owe me.
• After one round of trading each share of this
  security pays an amount V a random variable
  distributed uniformly on an interval 80, 120.
  Everybody knows this distribution.

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Rules (cont.)

• In a few seconds a trader will come into the room
  and will buy or sell a fixed number of shares,
  denoted by X, using a market order. You have to
  quote a Bid and an Ask price at which you are
  willing to make this trade.
• Remember that the number of shares she trades
  does not depend on the quoted price, but she will
  choose the best price out of all prices in this
  class. In other words you compete with your
  classmates for the trade. All of you must set
  quotes independently.

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Formal Model

• Risk averse dealer with inventory Y.
• Perfectly competitive market (simplification).
• The value of security, V, is a random variable
  with Mean m and STDEV s.
• Dealer has mean - variance preferences.
• Trade size is X.

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Dealer choice

• Perfect competition ensures that he is
  indifferent between buying (selling) and not
  trading.
• His action affects the risk he bears.
• Derive Bid and Ask prices, and the resulting
  Spread.
• Discussion.

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Variations of the model

• One sided
• Alternative competition models
• Yet the basic intuition remains if traders
  demand liquidity, they impose costs on the dealer
  (in general), and have to pay a premium to cover
  these costs.

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Exercise

• Reproduce the inventory model when there is 50
  probability that two traders (one buyer and one
  seller) will arrive simultaneously. The rest is
  as in class.
• If you cannot solve it, discuss the intuition.
• What happens to prices?
• What happens to spread?

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Lecture 4

• Dealer Markets Asymmetric Information Model

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Questions

• Risk neutral dealer is willing to provide
  liquidity from his inventory what are his
  considerations?
• Risk aversion? - No
• Competition? - perhaps.
• Inventory size? - No
• Trade size? - No
• Information?

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Bid for Money

• I hold in my hand an envelope with cash. The
  amount in the envelope is a random variable drawn
  from a Uniform distribution 25,75.
• Each of you gets a signal drawn from some
  distribution. The amount in the envelope is the
  expected value of your signal.
• You have to bid (sealed) to win the envelope.
  This is real money.

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Another Game

• On my way to class I saw that somebodys bicycle
  is stolen, and I know who owns it?
• Should I reveal the identity in public?
• Should I reveal it in private?
• Should I reveal privately, but in public?
• How much would you pay me for each of these
  options (to reveal or not to).

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Other examples

• Market for lemons.
• Winner's curse Auctions, IPOs.
• Conclusion One should infer hidden information
  from revealed actions, assuming rationality.

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Formal Model

• Risk neutral dealer.
• Perfectly competitive market (simplification).
• The value of security, V, is a random variable
  with Mean m and STDEV s.
• Dealer has mean - variance preferences.
• One trader knows V with probability l.

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Dealer choice

• A trade may signal information, in which case it
  is detrimental to the dealer.
• Otherwise the trade is profitable.
• If he is willing to quote prices to all, he must
  on average break even, thus he has to charge
  informationless traders for the losses caused by
  the informed.

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Why have noise traders?

• No trade Theorem.
• Suppose two people believe that the value of
  security is 1,..5 with equal probabilities.
• They have no incentives to trade.
• Suppose one gets a signal that values 5 is not
  viable while the other gets a signal that value
  1 is not viable. Now they differ in valuations
  will there be prices at which they will trade?

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Exercise Monopoly Dealer!

• Play Monopoly Dealer! game three times, and
  record your sessions. Use different settings each
  time.
• Analyze the printout of each session, and suggest
  improvements to your strategy.
• Winning money is not important for this exercise.

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Lecture 5

• Call Auction and Limit Order Book

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Questions

• Beliefs vs. Opinions.
• How does market aggregate information?
• You versus the market what should be your
  investment policy?

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Scenario 1 Opinions

• Many opinions exist in the market place.
• Each person conditions his demand for security on
  his own opinion, and on the price.
• Markets clear and the resulting price represents
  the weighted diversity of opinions of the
  participants.
• This is no different from the differing tastes
  for dresses determining their prices.

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Scenario 2 Beliefs

• The same as before, however now you would like to
  know the opinions of others to better estimate
  the true value.
• In this case you have two pieces of information
  your own noisy signal, and the aggregate signal -
  the price.
• Better use it in your decisions.

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What is different?

• Security price has another function, which is
  missing from the price of dresses - information.
• High prices increase the attractiveness of the
  stock, while low prices decrease it.
• Decline in variance increases the attractiveness.

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Conclusions

• Market price contains the aggregation of
  everybodys opinions.
• If you believe that others opinions are
  relevant, then you need to rely heavily on the
  price.
• If not, then place your bets...

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Limit Order Book

• No intermediaries
• Traders can submit market or limit orders fully
  strategic behavior.
• Market order demands liquidity and pay for it.
• Limit order supplies liquidity, but pays the cost
  of delay in execution.
• Traders differ in their level of patience.

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Conclusions

• Patient traders submit limit orders, impatient -
  market orders.
• Order submission strategy depends on the degree
  of competition holes.
• The book evolves over time.
• Simplicity.
• Multitude of empirical predictions.

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Lecture 6

• Different Modes of Competition in a Dealer Market

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Topics

• Discrete prices and their effect.
• Payment for order flow.

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Competition

• Competition with discrete prices.
• Cost per Unit 0.9 Prices 1, 2, 3 ...
• Suppose the inside spread exceeds the cost by two
  tick sizes - does an individual dealer want to
  reduce the spread?
• The answer is - NOT LIKELY!

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Ask
Tick
Spread
Cost
Tick
Bid
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Implications

• At least TWO competitive equilibria exist for any
  number of dealers.
• Price greater than cost does not necessarily mean
  collusion.
• Collusion in certain spread range cannot be ruled
  out by appealing to competitive forces.

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Odd Eighths Avoidance...

• ...or Preference for Spreads Two Ticks
• Above Cost (Spreads vs. Quotes).
• Coordination by convention.
• Once established no communication or enforcement
  required.
• Easy to break and hard to re-establish.
• Negative externality.

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Hypotheses

• Preference for two-tick above costs spreads
  regardless of the tick size
• Stocks quoted on 1/16th should avoid odd 1/16th
  quotes.
• Stocks quoted on 1/16th should not avoid odd
  1/8th quotes.
• Coordination implies higher profits
• Stocks which avoid odd 1/8ths must have higher
  spread, ceteris paribus.

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Payment for order flow

• Market makers contract directly with brokers for
  their entire order flow.
• Match NBBO.
• Pay brokers rebates (fees).
• Internalization.

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Brokers
Order Flow
Market
Makers
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Brokers
Large Trades
Small Trades
Market
Makers
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Brokers
Large Trades
Small Non-preferenced Trades
Market
Makers
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Flow of argument

• Avoidance Spread Preferencing

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Equilibrium Conditions

• Demand and Supply for preferenced trades.
• Market clearing
• Profit maximization by brokers in the choice of
  venue
• Profit maximization and individual rationality
  for market makers (entry and exit).

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Brokers Decision
Vertically Integrate
Use SOES
Preference
Brokers Volume
V
V
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Conclusions

• Price discreteness and payment for order flow may
  drastically alter the equilibria in the dealer
  market.
• Payment for order flow can exist in other market
  types as well.

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Lecture 7

• NYSE and Nasdaq Case Studies

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Goals

• Understand the evolution of these two major world
  equity markets.
• Evaluate the importance of institutional features
  (sometimes quite negligible at first glance).
• Understand the effect of regulatory environment
  on market performance.

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NYSE

• The first exchange in the US, to become the
  leading world exchange.
• Type of market trading floor / electronic order
  delivery call auction in the morning continuous
  double auction (LOB) specialist and floor
  traders during the day.
• Membership 1400, specialists 400.

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Recent History
Year Share Turnov Seat Aver Number
Volume Volume () Price Price
of Trades 1958 747 15 150 - 1968
2,932 24 210 9,704 1978 7,205 27 70
33 10,050 382 1988
40,850 55 700 37 17,739
1,366 1997 133,312 69 1,300 51
102,550 5,779
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Rights and responsibilities of the specialist

• Mandate to maintain a fair and orderly market.
• Why should they do this, rather than making
  money? Because this is conducive to making
  money. They act mostly as facilitators and
  brokers, but also as dealers.
• Can step before the limit order if improves the
  price, but has the last priority if does not.

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Order and Quote Delivery

• Order delivery systems
• SuperDot (Designated Order Turnaround) 600
  messages per second capacity
• BBSS (Broker Booth Support System) either
  directly to the specialists Display Book or to
  the Brokers booths and from there to the floor.
• ITS (Intermarket Trading System) Boston, Phily,
  Chicago, Cincinnati, Nasdaq, and ECNs.

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Listing requirements

• SRO
• Few firms do IPOs on NYSE they mostly transfer
  from other exchanges. Only large spin-offs of
  existing firms, large IPOs (Goldman), and foreign
  firms.
• Rule 500.

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Performance

• Volume shoots up when fixed commissions are
  abolished in 1975.
• Payment for order flow low commissions, new
  systems developed, speedy execution, trading over
  the Internet.
• Spreads declined over the last decade as volumes
  increased and became much lower following the
  introduction of 16th (percentage spreads declined
  even more since prices rose).
• NYSE volume share declines from 86 to 83 in 10
  years. Much less in small transactions (close to
  50).

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Upcoming changes

• Decimalization.
• More transparency.
• More automatic execution.

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Nasdaq

• Nasdaq was frequently used as an example of a
  perfectly competitive market
• homogeneous product
• many participants
• free entry
• immediately observable prices, quoted in advance.
• 1994 - 1998 witnessed 70-80 price decline!

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Features

• Dealer market with no floor.
• Competition as a comparative advantage.
• Traditionally considered as a Farm Team for the
  NYSE and AMEX. Place for firms to go public,
  before joining the big league.
• Fragmented trading venues.

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History

• 1973 - Creation of a computer network connecting
  the dealers - automated quotations.
• 1981 - SOES (Small Order Execution System)
• 1988 - SOES becomes mandatory (bandits)
• 1991 - Payment for order flow is OK
• 1994 - Christie and Schultz - avoidance
• 1997 - New rules 16th tick
• 2001 - Decimalization.

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Prior to 1997

• Fragmented trading venues (price grids)
• quotations ( indicates where they bind)
• SOES ()
• preferenced order flow ( - market)
• telephone
• SelectNet
• ECN
• Crossing networks.

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Payment for Order flow

• High profits from market making shift the
  competition for orders from quotes to direct
  payments.
• Small and medium-sized brokers sell their orders
  to wholesalers large brokers vertically
  integrate into market making.
• Incentives to quote aggressively disappear thus
  spreads widen, increasing the profits and
  payments.

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Christie and Schultz - 1994

• This paper caused 33 lawsuits (1.25Bln) SEC,
  and DOJ investigations, and market reform.
• Avoidance was very pervasive 70 of stocks
  priced above 10.
• Hard to predict.
• Affected mostly smaller trades (either SOES or
  preferenced).
• The effect on the quoted spread is in excess of
  0.20 or close to 1.5 of the stock price.

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Hypotheses

• Preference for round numbers
• Saving on negotiations costs
• Defense against SOES bandits
• Discrete prices yield multiple equilibria
  coordination rather than cartel enforcement (odd
  sixteenths avoidance).

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New Order Handling Rules

• SEC demands market reforms, which are implemented
  in Jan 1997
• Limit orders
• ECNs,
• Less fragmentation,
• Different equilibrium.
• Spreads decline by 27 volume does not change
  volatility does not change, and the cost of
  trading declines for all trade sizes. Estimated
  savings for investors 2 5 Bln per year.
  (Relative to 1994 much more).

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More reforms

• Predicted impact on the payment for order flow
• July 1997 - reduction of tick size stocks under
  the old trading system are barely affected large
  improvement in the stocks traded under the new
  OHR.
• Upcoming decimalization.
• Nasdaq today what is lost and what is gained.
  The sponsorship hypothesis.