Market Structure
Order – specifies what to trade, how much, buy or sell, and conditions
Orders are made because traders do not usually arrange their own trades – go through a
broker or dealer
Terms
Dutch Auction
Double Dutch Auction
Ask = offer
Bid
Size = quantity
Firm Price – for actively traded securities
Soft Price – for thinly traded securities
Best Bid and Best Offer
Inside Spread
Market liquidity – degree to which traders can trade without affecting prices
Offering or supplying liquidity (posting bid and ask quotes) – gives other traders an
opportunity to trade
Dealers make money by selling liquidity – posting bid and ask quotes
Standing order = open order → an open offer to trade
Taking liquidity – accepting an offer to trade
Market order – trade at the best price currently available in the market
Fills quickly, but perhaps at an inferior price
Market orders take liquidity from the market
Transaction cost = ½ the spread
Price Improvement – trader steps in front of best bid or ask to take an incoming market
order
Market Impact – traders move prices in order to fill their orders – the most significant
cost of trading large orders
Limit Orders – trade at the best price available, but only if it is no worse than the limit
price.
Limit Buy – trade at or below limit price
Limit Sell – trade at or above limit price
1
Marketable limit order – can be executed immediately
Standing limit orders are free options – but, unlike regular options, they can be cancelled
by the writer at any time
Options to trade
Sell limit orders are calls
Buy limit orders are puts
Strike is the limit price
Option value depends on the limit price and the volatility
Since bid and ask are limit orders (options), and options are worth more in volatile
markets, spreads tend to be wider as volatility increases
Compensation for offering liquidity – expect better prices than with market orders
You make money on the spread with a limit order, but the spread costs you money with a
market order
Stop orders – buy only after price rises to the stop price or sell only after price falls to the
stop price
Stop-loss orders are the most common
No guarantee sale will be at your specified price if price drops through it
Stop orders accelerate price changes
Market-not-held orders – trader instructs broker to use his/her discretion when filling the
order
Usually found with large orders and given to brokers who work on floor of
exchange
Day orders – good for that trading day only
GTC – good till cancelled
Fill-or-kill – no partial completions of this order – and do it now or not at all
2
Markets
Continuous Markets – arrange trades whenever the market is open
Call Markets – trade only when the market is called
Primary mkt for Treasuries is an example
NYSE starts as call but switches to continuous each day
Execution Systems
Quote driven with dealers = Dealer markets – dealers arrange trades and trade with
customers. Public traders don’t trade with each other.
Nasdaq is example
Interdealer brokers may help dealers arrange trades among themselves – offer
anonymity. Common in treasury market – Cantor Fitzgerald is most well-known
Order driven – buyers and sellers are matched by order precedence and trading price rules
They trade directly – without dealers
Traders offer or take liquidity
Futures exchanges, most stock and option exchanges and primary mkt for
Treasuries are examples
Hybrid markets – NYSE is order driven, but specialists will offer liquidity if needed
Order Precedence Rules – which buyers match with which sellers?
Trading Price Rules – once matched – at what price do they trade?
Minimum price increase – tick size
Transparency – degree and speed with which quotes and orders are made public
Stock markets are more transparent than bond markets
Most of the important exchanges in the world are order driven.
Most newly organized trading systems choose an electronic order-driven market
structure.
3
Oral Auctions
Example: U.S. Gov. T-bond Futures on CBT
500+ floor traders
bids and offers are called out
“take it” to accept offer
“sold” to accept bid
take turns bidding and offering as negotiating
All bids and offers must be public
First trader to accept gets to trade
Acceptances must be expressed publicly
Order precedence Rules
Primary – price priority
Secondary – time priority on futures exchanges
- public order precedence on U.S. stock exchanges
Price priority – precedence to traders who bid and offer the best prices (the inside spread)
Taders cannot accept bids or offers at any inferior price.
Can only bid or offer with price improvement
Time precedence – precedence to the traders whose bid or offer first improves the current
best bid or offer
After a bid or offer is accepted or withdrawn, anyone may bid or offer at a new price
Traders who want to trade ahead of a trader who has time precedence must improve the
price – this rewards aggressive pricing
But you must improve by at least the minimum price increment
This can involve some strategy
Public order precedence – members of the exchange cannot trade ahead of a public trader
who is willing to trade at the same price. This rule supersedes time precedence.
Decimalization has weakened this rule since it only costs a penny to step in front
of public orders.
All order matching markets use price priority as their primary order precedence rule.
There must be at least one secondary precedence rule to determine priority when several
traders bid or offer the same price
Time precedence
Display precedence (fully displayed vs. undisclosed)
Size precedence (can be smaller or larger)
Pro rata size allocations (used in Treasury Auction)
4
Discriminatory Pricing – used in oral auctions – every trade takes place at the price
proposed by the trader whose bid or offer is accepted.
Single Price Auction = Uniform Pricing – all trades take place at the same marketclearing price.
The last match that leads to a trade determines the clearing price
Used with Treasury auctions
Clears where supply meets demand
Continuous markets must use discriminating pricing
Call markets can use discriminating pricing or uniform pricing
Continuous rule-based order matching system with discriminatory pricing:
Order book is kept
When new order arrives – matching system attempts to trade with the order on the
opposite side with the highest precedence
If new order can’t trade immediately, it is placed in the order book according to
precedence
The limit price of the standing order determines the price for each trade
If an incoming order is large, it may be matched with several standing limit orders
– at each of their prices
Large impatient traders prefer discriminatory pricing rule over uniform pricing rule. It
allows them to trade the first parts of their orders at better prices than the latter parts.
Standing limit orders prefer uniform pricing rule so that large traders can’t discriminate
among them.
Limit order traders tend to issue more aggressively priced orders under uniform pricing
than discriminatory pricing
U.S. Treasury acuction switched from discriminating to uniform about 10 years
ago.
5