Topic 7
©R. Schwartz
Equity Markets: Trading and Structure
Slide 1
The Plain Vanilla
Order Drive Market
We have thus far considered
• The plain vanilla, order driven market
• A simple limit order book
• Continuous trading and call auction facilities
©R. Schwartz
Equity Markets: Trading and Structure
Slide 2
Is Trading Really This Simple?
©R. Schwartz
Equity Markets: Trading and Structure
Slide 3
Electronic Order Book Systems
Work Well For
• Retail order flow
• Liquid stocks
• Non-stressful conditions
But A Plain Vanilla
Electronic Trading System
Cannot do it All
©R. Schwartz
Equity Markets: Trading and Structure
Slide 4
More Structure is Needed!
©R. Schwartz
Equity Markets: Trading and Structure
Slide 5
The Need for Intermediation
• Emergence of the Modern Markets
• Intermediation on the New York Stock Exchange
• Intermediation at NASDAQ
Read on Your Own
Text Pages 217 - 238
©R. Schwartz
Equity Markets: Trading and Structure
Slide 6
The Ecology of an Order Driven
Market Can Break Down
• Free riding
• Small and mid-cap stocks
• Stressful conditions
©R. Schwartz
Equity Markets: Trading and Structure
Slide 7
Stressful Conditions
• A bear market
• Advent of news
• Derivatives expirations
• Momentum trading
• Daily openings
• Arrival of a 300,000 share order
©R. Schwartz
Equity Markets: Trading and Structure
Slide 8
Market Maker Operations
©R. Schwartz
Equity Markets: Trading and Structure
Slide 9
TraderEx Dealer Screen
©R. Schwartz
Equity Markets: Trading and Structure
Slide 10
Market Maker Services
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Immediacy
Supplemental liquidity
Price discovery
Animation
©R. Schwartz
Price improvement (pages 258-260)
Equity Markets: Trading and Structure
Slide 11
Immediacy
• Market maker practices are designed to facilitate
the rapid execution of customer orders
• However, orders are commonly traded
patiently (i.e., without immediacy)
– Upstairs negotiation of large block trades
– Breaking up large orders for submission
over time
– Limit orders
©R. Schwartz
Equity Markets: Trading and Structure
Slide 12
Market Maker Revenues
• Spread
• Trading the Order Flow
• Commissions
©R. Schwartz
Equity Markets: Trading and Structure
Slide 13
Market Maker Costs
• Inventory cost: Cost of carrying unbalanced
inventory
• Information cost: Cost of trading with better
informed participant
©R. Schwartz
Equity Markets: Trading and Structure
Slide 14
What Makes a Market Maker
Successful?
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Inventory control
Trading the order flow carefully
Ability to hide/disguise large positions
Knowledge of customers (source of the order flow)
is also important in practice
•
©R. Schwartz
Receiving a large percentage of the order flow
Equity Markets: Trading and Structure
Slide 15
Quotes and Inventory Positions
©R. Schwartz
Equity Markets: Trading and Structure
Slide 16
Inventory Control in TraderEx
• If P* jumps above your offer, your customers will, on
net, be buyers and your inventory will fall
• As your inventory falls, you raise your bid and offer
• The higher bid attracts sellers and the higher offer
discourages buyers
• What happens to your inventory if your bid is raised
above P*?
Your inventory is controlled by adjusting your bid
and offer relative to the unobserved P*
©R. Schwartz
Equity Markets: Trading and Structure
Slide 17
Transparency
As a Market Maker,
How Transparent Do You Want the Market To Be?
After you acquire a large inventory in the process
of servicing a customer, you must work off that
position
"Shares sold to a market maker are still
for sale”
You do not want your inventory revealed by a
trade publication
©R. Schwartz
Equity Markets: Trading and Structure
Slide 18
How Market Makers Compete
• Knowing their customers
• Offering an array of services
• Developing customer relationships; this results in
Preferencing
Quote matching
A market spread that is greater than it
would be in an order-driven environment
©R. Schwartz
Equity Markets: Trading and Structure
Slide 19
Market Maker Preferencing
What effect would preferencing have on
• The volume of orders you receive?
• Your inventory control?
• Your profitability?
Under which regime would you prefer to operate:
• Preferencing, or
• Strict price and time priorities?
©R. Schwartz
Equity Markets: Trading and Structure
Slide 20
Block Trading
©R. Schwartz
Equity Markets: Trading and Structure
Slide 21
The Challenge
How do you handle an order to buy half a
million shares of a stock that, on average,
trades 300,000 shares a day?
• Dealer capital
• Shop the order
• Slice and dice the order and submit the tranches to an
electronic platform
• Call auction
• Block trading facility
©R. Schwartz
Equity Markets: Trading and Structure
Slide 22
Costs
• Bid-ask spread
• Market impact
• Opportunity cost
• Implementation short fall
• Losses due to bad market timing
©R. Schwartz
Equity Markets: Trading and Structure
Slide 23
Performance Measure
Difficult to measure performance
• Need a good benchmark
• Do not make assessments on a trade-by-trade basis
• TraderEx point score
©R. Schwartz
Equity Markets: Trading and Structure
Slide 24
Electronic Intermediaries
Dark pools
• Crossing network (e.g., Posit, Matchpoint)
• Negotiation venue (e.g., Liquidnet)
• Order matching system (e.g., Pipeline)
©R. Schwartz
Equity Markets: Trading and Structure
Slide 25
Dark Pools
Free Riding On Price Discovery While Offering
Quantity Discovery
• Institutions keep their orders hidden to control
their transaction costs
• How do they find each other and trade?
• The problem is called Quantity Discovery
©R. Schwartz
Equity Markets: Trading and Structure
Slide 26
Shortcomings of Dark Pools
• Lack transparency
• Low crossing rates
• Exclusivity
• Sheer numbers
©R. Schwartz
Equity Markets: Trading and Structure
Slide 27
TraderEx Block Trading
Block Board
©R. Schwartz
Equity Markets: Trading and Structure
Slide 28
TraderEx Block Trading
• Institutional Orders
• Pipeline Order Flow is separated from the Order
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Book
Price of order execution is determined from the
Market (Order Book)
Minimum Order Size Constraints
©R. Schwartz
Equity Markets: Trading and Structure
Slide 29
TraderEx Pipeline Orders and
Execution
• Passive Order – Bid price is below the
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bid/ask spread midpoint
Active Order – Bid price is above the
midpoint
Vice versa for ask price
Market / Limit
Reward for being Aggressive
©R. Schwartz
Equity Markets: Trading and Structure
Slide 30
TraderEx Pipeline Colors and
Features
• Orange : There is a pipeline
order for that stock
• Orange with Red : You have
placed a sell order
• Orange with Green : You have
placed a buy order
• Yellow with Green : You have
placed an aggressive buy order
and there is a passive sell order
• Yellow with Red : You have
placed an aggressive sell order
and there is a passive buy order
©R. Schwartz
Equity Markets: Trading and Structure
Slide 31
TraderEx Pipeline
• Take (Hit) the Passive Offer (Bid)
• Bid/Ask spread protection
Take Bid
©R. Schwartz
Equity Markets: Trading and Structure
Slide 32