Kee H. Chung
State University of New York at Buffalo

 Traditional asset pricing aims to understand what should be the price of a security.
 It does not, however, address how prices adjust to reflect news.

Nor does it explain how investors’ subjective assessment of a security “get into” the price.


In practice, news and investors’ valuations are incorporated into security prices through trading .
 This means that the specific trading rules, and the strategies traders develop in response to these rules, will affect how asset prices change over time in response to new information.


“Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.”
(Maureen O’Hara, a former president of the
American Finance Association)
 Market microstructure has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.

 Data guided by theory, theory guided by data
 Market design issues
Agency auction market
Dealer market
Electronic limit order books

 Market performance issues
• Transaction costs
• Shock absorption/resiliency
• Trading halts
 Efficiency – welfare issues
• Is insider trading bad?

 Orders and order properties
 Market structure
 Order-driven markets
 Dealer markets

 Informed trading and market efficiency
 Bid-ask spreads
 Measurement of trading (execution) cost
 Adverse selection models
 Spread component models

 Trade classification
 Nasdaq controversy, stock price clustering, and SEC market reforms
 Order preferencing
 Market structure and execution costs
 High frequency trading (HFT)
 Market segmentation: Efficiency vs competition
 Minimum price variation (tick size) and decimalization

 Competition in dealer market
 Intraday patterns and test of alternative theories
 Spread and depth: Joint decision variables
 Trades, information, and prices
 Commonality in liquidity
 Liquidity and asset pricing
 Market microstructure and interactions with other areas

 Orders are instructions to trade that traders give to brokers and exchanges that arrange their trades.
 Orders always specify
•
•
• The security to be traded
The quantity to be traded
The side of the order (buy or sell)

 Orders may specify
•
•
•
• Price specifications
How long the order is valid
When the order can be executed
Whether they can be partially filled or not

 Traders that either do not have direct access to the markets, or do not have the time to monitor the markets use orders.
•
• Have to anticipate what is going to happen.
Have to clearly delineate contingencies. Use standard orders to avoid mistakes.


• Risk of misunderstandings
• Conflicts of interest
• Speed of reaction to changing market conditions
• Cancellations can be time consuming
• Access to order flow information

 Bid : buy order specifying a price (price is called the 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.

 Dealers have an obligation to continuously quote bids and offers, and the associated sizes (number of shares), when they are registered market markers for the stock.
 Their quotes also have to be firm during regular market hours.

 Public orders with a price limit can also become the market bid or offer if they are at a better price than those currently quoted by a registered market maker.

The market’s best bid and offer constitute the inside market, the best bid/ask, or the
BBO. The best bid and offer across all markets trading an instrument is called the
NBBO.

 The difference between the best offer and the best bid is the bid/ask spread, or the inside spread (touch).
 Orders supply liquidity if they give other traders the opportunity to trade.
 Orders demand liquidity (immediacy) if they take advantage of the liquidity supplied by other traders’ orders.

 Orders submitted by traders for their own account are proprietary orders.
• Broker-dealers and dealers.
 Since most traders are unable to directly access the markets, most order are instead agency orders.
• Presented by a broker to the market.

Instruction to trade at the best price currently available in the market.
•
•
•
Immediacy
Buy at ask/sell at bid => pay the bid/ask spread
Price uncertainty
 Fills quickly but sometimes at inferior prices.

 Used by impatient traders and traders who want to be sure that they will trade. It is usually thought that insiders use that type of order.
 When submitting a market order execution is nearly certain but the execution price is uncertain.
 Takes liquidity from the market in terms of immediacy. They then pay a price for immediacy, which is the bid-ask spread.

Suppose that the quote is 20 bid, 24 offered.
Suppose that the best estimate of the true value of the security is 22.
 A market buy order would be executed at 24 for a security worth 22.
 The price paid would be 24 and therefore the price of immediacy would then be 2.

 A market sell order would be executed at
20 for a security worth 22.
 The price received would be 20 and therefore the price of immediacy would then be 2.
 The price of immediacy is the bid-ask spread.

 Price improvement is when a trader is willing to step up and offer a better price than that of the prevailing quotes (at order arrival).
 Who benefits from price improvement?
 Who loses from price improvement?

 Large market orders tend to move prices.
 Liquidity might not be sufficient at the inside quotes for large orders to fill at the best price.
 Prices might move further following the trade.
• Information and liquidity reasons.

 For example, suppose that a 10K share market buy order arrives in IBM and the best offer is $100 for 5K shares.
 Half the order will fill at $100, but the next 5K will have to fill at the next price in the book, say at $100.02 (where we assume that there is also 5K offered).
 The volume-weighted average price for the order will be $100.01, which is larger than $100.00.

 A limit order is an instruction to trade at the best price available, but only if it is no worse than the limit price specified by the trader.
• For a limit buy order, the limit price specifies a maximum price.
• For a limit sell order, the limit price specifies a minimum price.

 If you submit a limit buy order for 100 shares (round lot) of Dell with limit price of
$20 . This means that you do not want to buy those 100 shares of Dell at a price above $20 .
 If you submit a limit sell order for 100 shares (round lot) of Dell with limit price of
$24 . This means that you do not want to sell those 100 shares of Dell at a price below $24 .

 If the limit order is executable (marketable), than the broker (or an exchange) will fill the order right away.
 If the order is not executable, the order will be a standing offer to trade.
• Waiting for incoming order to obtain a fill.
• Cancel the order.
 Standing orders are placed in a file called a limit order book.

 Marketable limit order : order that can immediately execute upon submission (limit price of a buy order is at or above the best offer),
 At the market limit order : limit buy order with limit price equal to the best bid and limit sell order with limit price equal to the best offer,
 Behind the market limit order : limit buy order with limit price below the best bid and limit sell order with limit price above the best offer.

Market Microstructure Seminar - T&E Chapter 4

Market Microstructure Seminar - T&E Chapter 4

 A limit sell order is a call option and a limit buy order is a put option. Their strike prices are the limit prices.
 A limit order is not an option contract (not sold).
 The option is good until cancelled or until the order expires.
 The value of the implicit limit order option increases with maturity.

 The compensation that limit order traders hope to receive for giving away free trading options is to trade at a better price.
 However, options might not fill (execution uncertainty).
• Chasing the price.

 Limit order traders might also regret having had their order filled (adverse selection)…
• What could cause a limit order to regret obtaining a fill?
• How would this fact affect strategies involving limit orders?

Market Microstructure Seminar - T&E Chapter 4

Market Microstructure Seminar - T&E Chapter 4

Market Microstructure Seminar - T&E Chapter 4

 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).
 Buy only after price rises to the stop price.
 Sell only after price falls to the stop price.

 Stop orders are typically used to close down losing positions (stop loss orders).
 Mainly used on market orders and few on limit orders.

Example: Suppose that the market for Dell is currently 20 bid, 24 offered.
 Suppose that you place a stop loss order for
1,000 shares of Dell at a stop price of 15.
 Suppose that after having placed that order, the market falls to: 13 bid, 15 offered. The bid price passed your stop price .
 Your order is then executed at 13 provided there is enough quantity at that price.
 The stop price may not be the price at which you are executed, as above.

 The difference lies in their relation with respect to the order flow.
 A stop loss order transacts when the market is falling and it is a sell order. Therefore such an order takes liquidity away from the market (it must be accommodated so it provides impetus to any downward movement).

 A limit order trades on the opposite side of the market movement. If the market is rising, the upward movement triggers limit sell orders.
 Outstanding limit orders provide liquidity to the market.

 Traders who want to condition their orders on the last price change submit ticksensitive orders.
• Uptick = current price is above the last price
• Downtick = current price is below the last price
• Zero-tick = current price is the same as last price

 Do tick-sensitive orders demand or supply liquidity?
 How do tick-sensitive orders compare to limit orders?
 How are tick-sensitive orders affected by the minimum price-increment?

 Day orders (DAY)
 Good-till-cancel (GTC) orders
 Fill-or-kill (FOK) orders, good-on-sight orders
 Good until orders
 Good-after-orders
 Good-this-week
(GTW) orders, goodthis-month (GTM) orders


Market-on-open
(MOO) orders
Market-on-close
(MOC) orders
 Immediate-or-cancel
(IOC) orders

 All-or-none (AON) orders
 Minimum-or-none (MON) orders
 All-or-nothing, and minimum acceptable quantity instructions

 Spread orders
 Display instructions
• Hidden/Ice-berg/reserve orders
 Substitution orders
Special settlement instructions
•
• Regular-way settlement
Cash settlement
• How do these affect the cost of trading?

 Trades take place during trading sessions .
•
• Continuous market sessions
Call market sessions

 Traders may trade at anytime while the market is open.
 Traders may continuously attempt to arranger their trades.
 Dealer markets or quote driven markets are, by definition, continuous markets.

 Pros for continuous markets
•
• Traders can arrange their trades whenever they want.
Information may be incorporated very fast into prices.
 Cons for continuous markets
• more volatile

 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, NYSE,…). Also used for less active securities, bonds,….

 Pros for call markets
• Focus the attention of traders on the same security at the same time.
• Less volatility
 Cons for call markets
• Information may need a lot of time to be incorporated into prices.


quote-driven markets order-driven markets brokered markets hybrid markets

 In pure quote-driven markets , dealers participate in every trade.
 Dealers provide all the liquidity and quote bid and ask prices. Those quotes are firm for some specified size, i.e., the dealers must honor them.
 If the investor wants to trade a different size, there will be negotiation between the investor and the dealer.


Buy orders decrease the dealer’s inventory position whereas sell orders increase the dealer’s inventory position.
 The dealer can then attract or reject order flow given her inventory position. The bidask spread’s placement will then reflect her inventory position.


When the dealer’s inventory position is low, she sets both a high bid price and a high ask price.

When the dealer’s inventory position is high, she sets both a low bid and a low ask.

Examples of Dealer Markets :
•
•
•
•
NASDAQ
London International Stock Exchange
(SEAQ)
OTC Bond Markets
Foreign Exchange Markets



Multiple dealers, geographically dispersed, electronically linked.
No consolidation of trading: No “floor”.
 Virtually all customer trades are with a dealer.
 The dealer is the intermediary.
 Customers rarely trade against other customers.
 Dealers trade among themselves.
 Regulation and transparency are poor relative to floor markets.
 Dealers may compete among themselves, but have a lot of information and market power relative to customers.

 Two or more market makers per stock
 Trades were mainly phone negotiated
 Roughly 95% of the volume went through MM book
 No central limit order book.
 Small order execution automated, but not larger orders.
 Complete decentralization

 Provide quotes during trading hours

Offer “best execution”
 Report trades in a timely manner
 Fair communication

 In an order-driven auction market, all traders issue orders to the exchange.
 Buyers and sellers regularly trade with each other without the intermediation of dealers.
 But dealers may choose to trade.
 Order driven markets may be organized as continuous markets or as call markets.

 Brokers match up buyer and seller.
• Search is often required to match buyer and sellers for less liquid items, and for large blocks of securities
• Brokers specialize in locating counterparts to difficult orders
• Concealed traders
• Latent traders

 Examples of brokered markets include:
• Block trading (stocks and bonds)
• Real estate
• Business concerns

Hybrid markets mix aspects of the various structures.
 The most common hybrid markets are those with dealer-specialists.
 These markets are order-driven auction markets in which the specialist must provide liquidity under some circumstances.
 Most US stock exchanges and options exchanges have specialist systems.

 It is of utmost important that orders are not lost and that order instructions are understood.
•
• Ticker symbols
Order routing systems
•
• Order presentation systems
Messaging systems

 The information created by trading is valuable.
•
•
Market data systems report trades to the public
Broadcast services



Price and sale feeds
Ticker tapes
Quotation feeds
 Transparency is a key feature of markets.
• Ex ante vs. ex post transparency

 Most important exchanges are orderdriven markets.
 Most newly organized trading systems are electronic order-driven markets.
 All order-driven markets use order precedence rule and trade pricing rule .

- Tokyo Stock Exchange,
- KSE, KOSDAQ
- Paris Bourse,
- Toronto Stock Exchange,
- Most Future Markets,
- Most European Exchanges for equities
(Milan, Barcelona, Madrid, Bilbao,
Zurich,….)

 Oral auctions
 Rule-based order matching systems
•
•
•
Single price auctions
Continuous order book auctions
Crossing networks

In order-driven markets, trading rules specify how trades are arranged:
order precedence rules : match buy orders with sell orders
1. Price priority
2. Time precedence or time priority
trade price rules : determine the trade price
1. Uniform pricing rule (single price auction)
2. Discriminatory pricing rule

 Used by many futures, options, and stock exchanges.
• The largest example is the US government long treasury bond futures market (CBOT, 500 floor traders).
 Traders arrange their trades face-to-face on an exchange trading floor.
•
•
•
• Cry out bids and offers (offer liquidity)
Listen for bids and offers (take liquidity)
“Take it” = accept offer
“Sold” = accept bid


•
•
•
Traders must publicly announce their bids and offers so that all other traders may react to them (no whispering…).
Traders must also publicly announce that they accept bids/offers.
Why is this necessary?


• Price priority
 Should a trader be allowed to bid below the best bid, above the best ask in an oral auction?
• Time precedence
 Is time precedence maintained for subsequent orders at the best bid or offer? Why? Why not?

How can a trader keep his bid or offer “live”?
 The minimum tick size is the price a trader has to pay to acquire precedence.
• Public order precedence
 Why do you think this is necessary?


• Trades take place at the price that is accepted, i.e., the bid or offer.
• Discriminatory pricing rule.
 Why do you think it is called discriminatory? Who gets the surplus?


• Trading floors can be arranged in several rooms as on the NYSE, with each stock being traded at a specific “trading post.”
• Trading floors can also be arranged in “pits” as in the futures markets.

 Used by most exchanges and almost all
ECNs.
 Trading rules arrange trades from the orders that traders submit to them.
 No face-to-face negotiation.
 Most systems accept only limit orders.
• Why do you think most systems are reluctant to accept market orders?

 Orders are for a specified size.
 Electronic trading systems process the orders.
 Trades may take place in a call, or continuously.
• A new order arrival “activates” the trading system.
 Systems match orders using order precedence rules, determine which matches can trade, and price the resulting trades.


• Market orders always rank above limit orders.
• Limit buy orders with high prices have priority over limit buy orders with low prices
• Limit sell orders with low prices have priority over limit sell orders with high prices.


• Under time precedence , the first order at a given price has precedence over all other orders at that price. Gives orders precedence according to their time of submission.
• The pure price-time rule uses only price priority and time precedence.
• Floor time precedence to first order at price. All subsequent orders at that price have parity (Oral auction)


• Why do markets use display precedence?

• Some markets give precedence to small orders, other markets favor large orders
(NYSE).

• Public orders have precedence over member orders at a given price.

 Trades are arranged by matching the highest ranking buy orders with the highest ranking sell orders.
 Order precedence rules are used to rank orders.
 Order precedence rules vary across markets. However, the first rule is almost always price priority .

 All matched orders are executed at the same price.
 This rule is used for opening markets in many equities markets, following trading halts for many continuous markets, and in the AZX,….

 In a continuous market trade takes place when an incoming order is matched with a standing limit order.
 Under the discriminatory pricing rule , the trade price is the limit price of the standing limit order.

Time Trader Buy/Sell Size
12:02
12:06
12:15
12:16
12:20
12:21
12:24
12:25
12:27
12:27
Sammy
Steve
Bern
Susie
Ben
Bob
Sandy
Bev
Bill
Seth
Sell
Sell
Buy
Sell
Buy
Buy
Sell
Buy
Buy
Sell
100
200
500
300
200
100
500
500
200
200
Price
$20.05
$20.06
$20.06
$20.08
Infinite
$20.08
$20.12
$20.08
$20.05
$20.10

Sellers Buyers
Trader Size
Sammy 100
Steve 200
Susie 300
Seth 200
Sandy 500
Price Size
$20.05
200
$20.06
500
$20.08
100
$20.08
500
$20.10
$20.12
Infinite 200
Trader
Bill
Bern
Bob
Bev
Ben

Clearing the order book with a call at 12:30
Sellers Buyers
Trader Size
Sammy 100 0
Price Size
$20.05 200
Trader
Bill
Steve
Susie
Seth
200 100 0 $20.06 500
$20.08 100
300 0
200
Sandy 500
$20.08 500 200 Bev
$20.10
$20.12
Bern
Bob
Infinite 200 0 Ben

Buyer Seller Quantity Price?
Ben
Ben
Bob
Bev
Sammy 100
Steve 100
Steve 100
Susie 300
Infinity,
$20.05
Infinity,
$20.06
$20.08,
$20.06
$20.08

Sellers Buyers
Trader Size Price Size Trader
$20.05
200 Bill
$20.06
500
$20.08
200
Bern
Bev
Seth 200 $20.10
Sandy 500 $20.12

 Possibilities include:
• Infinite
•
•
•
$20.05
$20.06
$20.08
 The price/prices depends on the trade pricing rules.


•
Single price auctions use the uniform pricing rule:
Everyone gets the same price.

•
Continuous two-sided auctions and a few call markets use the discriminatory pricing rule.
Trades occur at different prices.

•
Crossing networks use the derivative pricing rule.
The price is determined by another market.


All trades take place at the same “market clearing price.”
• The market clearing price is determined by the last feasible trade.
 Matching by price priority implies that this market clearing price is also feasible for all previously matched orders.

 In Example 1, the last feasible trade is between Bev and Susie, so the market clearing price is $20.08.
• Sam, Steve and Susie are happy with a market clearing price of $20.08 since they were willing to sell at $20.08 or lower.
• Ben, Bob, and Bev are happy to with a market clearing price of $20.08 since they were willing to buy at $20.08 or higher.

 If the buy and sell orders in the last feasible trade specify different prices, the market clearing price can be at either the price of the buy or the price of the sell order.
 The trade pricing rules will dictate which one to use.

 The single-price auction clears at the price where supply equals demand.
• At prices below the market clearing price, there is excess demand.
• At prices above the market clearing price, there is excess supply.

 Single price auctions maximize the volume of trading by setting the price where supply equals demand.
• Because prices in most securities markets are discrete, there is typically excess demand or excess supply at the market clearing price.
• In the Example, what is the excess demand or supply?

 The single price auction also maximizes the benefits that traders derive from participating in the auction.
• Trader surplus for a seller = the difference between the trade price and the seller’s valuation
• Trader surplus for a buyer = the difference between the buyer’s valuation and the trade price.
• Valuations are unobservable, but we may assume that they at least are linked to limit prices.

$20.13
$20.12
$20.11
$20.10
$20.09
$20.08
$20.07
$20.06
$20.05
$20.04
0 300 600 900 1200 1500
Supply
Demand

 Continuous two-sided auction markets maintain an order book.
• The buy and sell orders are separately sorted by their precedence.
 The highest bid and the lowest offer are the best bid and offer respectively.

• When a new order arrives, the system tries to match this order with orders on the other side.


If a trade is possible, e.g., the limit buy order is for a price at or above the best offer, the order is called a marketable order.
If a trade is not possible, the order will be sorted into the book according to its precedence.

 Under the discriminatory pricing rule, the limit price of the standing order dictates the price for the trade.
 If the incoming order fills against multiple standing orders with different prices, trades will take place at multiple prices.

Sellers Buyers
Trader Size Price Size
Sammy 100 $20.05
$20.06
$20.08
$20.08
$20.10
$20.12
Infinite
Trader

Sellers
Trader Size
Sammy 100
Steve 200
Price
$20.05
$20.06
$20.08
$20.08
$20.10
$20.12
Infinite
Buyers
Size Trader

Sellers Buyers
Trader Size Price
Sammy 100 0 $20.05
Size Trader
Steve 200 0 $20.06
500 200 Bern
$20.08
$20.08
$20.10
$20.12
Infinite

Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0 $20.05
Steve
Susie
200 0
300
$20.06
$20.08
$20.08
$20.10
$20.12
500 200 Bern
Infinite

Sellers
Trader Size Price
Buyers
Size Trader
Sammy 100 0
Steve 200 0
Susie 300 100
$20.05
$20.06
$20.08
$20.08
500 200 Bern
$20.10
$20.12
Infinite 200 0 Ben

Sellers Buyers
Trader Size Price Size Trader
Sammy 100 0
Steve 200 0
$20.05
$20.06 500 200 Bern
Susie 300 100 0 $20.08 100 0 Bob
$20.08
$20.10
$20.12
Infinite 200 0 Ben

Sellers
Trader Size
Buyers
Price Size Trader
Sammy 100 0
Steve 200 0
$20.05
$20.06
500 200 Bern
Susie 300 100 0 $20.08
100 0 Bob
Sandy 500
$20.08
$20.10
$20.12
Infinite 200 0 Ben

Sellers Buyers
Trader Size
Sammy 100 0
Price Size
$20.05
Trader
Steve 200 0 $20.06
500 200 Bern
Susie 300 100 0 $20.08
100 0 Bob
$20.08
$20.10
500 Bev
Sandy 500 $20.12
Infinite 200 0 Ben

Sellers
Trader Size
Seth 200
Sandy 500
Buyers
Price Size
Sammy 100 0
Steve 200 0
$20.05
200 Bill
$20.06
500 200 Bern
Susie 300 100 0 $20.08
100 0
$20.08
500
Bob
Bev
$20.10
$20.12
Infinite 200 0
Trader
Ben

Buyer Seller Size Price Bid Offer
$20.05x100
$20.06x100
Bern
Bern
Sammy 100
Steve 200
$20.05
$20.06
$20.06x200
$20.06x200
$20.08x300
Ben Susie 200 $20.08
$20.06x200
$20.08x100
Bob Susie 100 $20.08
$20.06x200
$20.06x200
$20.08x500
$20.08x500
$20.12x500
$20.12x500
$20.10x200

 Taking the orders as given, large impatient traders (e.g., liquidity demanders: marketable limit orders) prefer the discriminatory pricing rule (to exploit better price).
 Taking the orders as given, standing limit order traders (liquidity suppliers) prefer the uniform pricing rule (to maximize surplus).

 However, orders are not given.
•
• Limit order traders tend to price their orders more aggressively under the uniform pricing rule.
Can you explain this prediction?
• Why would large traders want to split their orders when trading under the uniform pricing rule?
• What role can trading halts have in affecting the pricing rules?

 The single price auction produces a larger trader surplus than the continuous auction when processing the same order flow
(example).
•
•
Concentration of order flow increases total trader surplus.
In practice, traders will not send the same order flow to call and continuous markets.

 The single price auction will typically trade a lower volume than the continuous auction.
•
• In our example, both trade 600 shares…
See textbook example (Table 6-7 & 6-8)
 However, there is another benefit of the continuous market – it allows traders to trade when they state their demands.

Example 2: Batch market and surplus

In that case orders are arranged as soon as they arrive if they can be matched with outstanding orders.
At 10:00, Sean submits the first order (a limit buy order with price 200 for 300 shares). As the book is empty, his order will have to wait in the order book.
At 10:02, Siobhan submits the second order (a limit sell order with price 201 for 200 shares). As the maximum price for the limit buy order is lower than the minimum price for the limit sell order, those two orders cannot be matched. As a result, the market is 200 bid for 300, 200 offered at 201. The bid-ask spread is 1.

 Centralized order-driven market with automated order routing.
 Decentralized computer network for access.
 Member firms act as brokers or principals.
 No designated market makers
 Central limit order book/information system/clearing and settlement
 Off-book trading is sometimes significant

 The broker might have other limit orders besides ours. A collection of unexecuted limit orders is a “book”.
 The book may have buy and sell orders.
 In US futures pits, each broker may have his/her own book.
 In many other markets, the book is consolidated : all unexecuted limit orders are recorded in one book.

 All orders are limit orders.
 The book is electronically visible.

“Anyone” may enter an order.
 There has to be some established relationship for clearing and credit purposes.
 The electronic limit order book is probably the most common form of new market organization today, but it is far from universal.

 Island is a limit order market
 Island is an Electronic Communications
Network (ECN)
 It has no trading floor. All orders are sent electronically.

 Some markets have a single consolidated limit order book, where everything happens.
This is mostly true of the Tokyo Stock Exchange,
Euronext, the Singapore Stock Exchange, the
Taiwan Stock Exchange, etc., etc.
 Other markets are fragmented.
There are multiple limit order books in different physical venues (or computers).

 In addition to the Island ECN, there is a limit order book for IBM at the New York
Stock Exchange, the Boston Stock
Exchange, the Pacific Stock Exchange, etc., etc.
 The largest (deepest) limit order book for
IBM is at the NYSE.

 The pit markets in US futures exchanges do not have a centralized limit order book.
 The Chicago Board Options Exchange does have a centralized book (run by a clerk).
 The NYSE has a limit order book, run by the specialist. (But there are other books in
NYSE-listed stocks on regional exchanges and other dealers.)
 NASDAQ has multiple books.

 A centralized limit order book is often referred to as a “CLOB” (pron. kl.b)
 Hard CLOB: All activity is forced (by law) through the book.
 Soft CLOB: A CLOB exists, but trades can take place outside of it.

 Electronic limit order books are the predominant continuous trading mechanism.
 They do not seem to work well, however, in all circumstances. These include large trades, low activity securities and market breaks (“crashes”)
 In these circumstances, some sort of active marketmaking presence (a dealer) seems to be necessary.

 Acquire and act on information about fundamental values.
 Buy (sell) when prices are below their estimates of fundamental value.
 Include value traders, news traders, information-oriented technical traders, and arbitragers.

 The true values
 Not perfect foresight values
 Prices are said to informative when they are equal to fundamental values
 Fundamental values are not predictable
(why?)
 Price changes in efficient markets are not predictable (why?)

 Because they buy (sell) when price is below
(above) their estimates of fundamental value, their trading move prices toward their estimates of fundamental value.
 When informed traders accurately estimate values, their trading makes prices more informative.

The market price is more informative
(accurate) than individual value estimates
V = the true fundamental value,
P = the market price, v i
= value estimate of trader i; v i
= V + e i
, where E(e i
) = 0,
D i
= trader i’s desired position in the security;
D i
= a(v i
– P), where a is a constant.
From ∑ D i
= ∑ a(v i
– P) = 0 (i.e., zero net supply), we have
∑ a(v i
→ ∑v i
– P) = 0 → a∑(v i
– P) = 0 → ∑(v
= ∑P = N * P → P = (1/N) ∑v i i
– P) = 0 → ∑v i
– ∑P = 0
P = (1/N) ∑v i
= (1/N) ∑( V + e i
) = V + e
M
, where e
M
= (1/N) ∑e i
≈ 0.

 Must minimize price impact to maximize profits.
 Trade aggressively when their private information will soon become common knowledge.
 Trade slowly when their private information will not soon become common knowledge.
 Trade aggressively when other traders will act on the same information.

Strategic
Trading with Private Information and Price Impact
 If you buy a contract, you receive $1 with a probability of π and zero with 1- π.
 The market price of the contract is
P = 0.3 + ¼(Q/L), where Q is your trade size and
L denotes liquidity.
Your profit = πQ – PQ = πQ – [0.3 + ¼(Q/L)]Q
Your profit is maximized when Q = 2L( π – 0.3)
Your maximum profit = L( π – 0.3) 2

 Value traders – all information
 News traders – new information
 Information-oriented technical traders – predictable price patterns
 Arbitragers – relative instrument values rather than absolute instrument values

 Precise and orthogonal estimates
 Impossibility of informationally efficient markets (Grossman and Stiglitz)
 Three forms of efficient markets hypothesis

 Front runners, Sentiment-oriented technical traders, Squeezers, Manipulation of stop orders
 They do not make prices more informative or markets more liquid.
 Tick size is important.
 They are all parasitic traders.

 Front running aggressive traders
•
• Profit from the price impact of aggressive traders. Discuss example.
Illegal when they violate a confidential brokerage relationship.
 Front running passive traders
• Quote matching or penny jumping. Discuss example.
• Extract option values of the standing orders.

 Make prices less informative when they front run uninformed traders.
 Make prices more informative when they front run informed traders.
 Long-run effect of informed traders may be to make market prices less informative!
• Why? Because traders invest less in information due to smaller profits.

 Front runners make markets less liquid.
 They benefit the traders with whom they trade when they improve prices to step in front of other traders.
 They do so at the expense of the traders they front run. (Extracting option values)
 Some traders become less aggressive when confronted with front runners.

 They try to predict the trades that uninformed traders will decide to make.
 They profit from the price impact of uninformed trades.
 Their trading make market prices less informative because they try to trade before uninformed traders.
 They make markets less liquid for the traders they front-run.

 They try to monopolize one side of a market so that anyone who must liquidate a position on the other side must trade with them.
 Make prices less informative due to price manipulation.
 Illegal in the US.


“ Gunning the market”
 Push prices up or down to activate stop orders.
 Stop orders then accelerate those price changes.
 They close their positions at a profit by trading with the stop orders! Use example.
 Illegal in the US. But almost impossible to enforce.

 A broker acts as an agent for a customer, representing customer orders in the market
(e.g., a real estate broker).
 A dealer takes the other side of customer trades (e.g., a used-car dealer).
 Much of US securities regulation applies to both brokers and dealers. The US Securities and Exchange Commission (SEC) refers to such people as “broker-dealers”. In fact, broker and dealer functions are quite distinct.

 Dealer spread vs. inside spread
 One-sided vs. two-sided market
 Firm vs. soft quotes
 Quoted vs. realized spread
 Best execution rule
 Order preferencing

 The bid-ask spread is the difference between the ask price and the bid price
( quoted spread ) .
 The quoted spread gives an estimation of the remuneration of the service provided by dealers to traders. The remuneration increases with the spread.
 Dealers make money by buying low and selling high. They lose money when market conditions lead them to buy at high prices and sell at low prices.

The realized spread (difference between the price at which dealers effectively buy and sell their securities) is the true remuneration of providing liquidity.

 Inventories are positions that dealers have on the security they trade. They may hold a long position or a short position.
 Target Inventories are positions that dealers want to hold.

Dealers’ inventories are in balance when they are near the dealers’ target levels and out of balance otherwise.

 For risk averse dealers any difference between 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 risk the dealer must assume and the greater the compensation required by dealers.

 Dealers may act to control their inventories.

As dealers’ prices affect other traders’ trading decisions, the placement of the dealers’ bid-ask spread may be used to control their inventories.

When 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 from selling to them and higher ask prices discourage traders from buying from them.
 Dealers decrease their prices when they want to decrease their inventory.
• Lower bid prices discourage traders from selling to dealers and lower ask prices encourage traders from buying from the dealers.

 Diversifiable inventory risk
•
• When future price changes are independent of inventory imbalances
Can be minimized by dealing in many instruments
 Adverse selection risk
• When future price changes are inversely related to inventory imbalances
• Arises when dealers trade with informed traders

 Informed traders buy when they think that prices will rise and sell otherwise.
 When dealers trade with informed traders,
• prices tend to fall after the dealers buy and rise after the dealers sell (i.e., future price changes are inversely related to inventory imbalances)
• their realized spreads are often negative .

 Dealers always gain to liquidity-motivated transactors.
 Dealers can balance the losses made on informed trading with the profits made on uninformed trading.

 Raise ask price and lower ask size
 Raise bid price and increase bid size
 Buy from another trader at his ask price
 Buy a correlated instrument

 Lower ask price and raise ask size
 Lower bid price and reduce bid size
 Sell to another trader at his bid price
 Sell a correlated instrument

 Ask price = the best estimate of fundamental value, conditional on the next trader being a buyer. (regret-free price)
 Bid price = the best estimate of fundamental value, conditional on the next trader being a seller.
 Because dealers generally do not know whether the next trader is well informed, they use the probability that the next trader is well informed.

 The spread is the compensation dealers and limit order traders receive for offering immediacy.


The most important factor in order placement decision (market vs. limit orders)
The most important factor in dealer’s liquidity provision decision
 The most important chapter of the book.

 Monopoly dealers
 Low barriers to entry in most markets
 In many markets, dealers face competition from public limit order traders
 Normal vs. economic profits – Dealers earn only normal profits in competitive dealer markets

 Transaction cost component
•
•
• Transitory spread component
Covers the normal costs of doing business, monopoly profits, risk premium
Responsible for bid-ask bounce
 Adverse selection component
• Compensate dealers for losses to informed traders
• Permanent spread component

 Information perspective
• The difference in the value estimates that dealers make conditional on the next trader being a buyer or a seller
 Accounting perspective
• The portion of the spread that dealers must quote to recover from uninformed traders what they lose to informed traders

V = the unconditional value of a security
P = the probability that the next trader is an informed trader
V+E = the value of the security when an informed trader wants to buy
V-E = the value of the security when an informed trader wants to sell
The next trader is equally likely to be a buyer or a seller.

Conditional expectation of the security value given that the next trader is a buyer
= (1-P)V + P(V+E) = V + PE
Conditional expectation of the security value given that the next trader is a seller
= (1-P)V + P(V-E) = V - PE
Adverse selection component of the spread
= (V + PE) – (V - PE) = 2PE

Let B is the dealer’s bid price and A is the dealer’s ask price.
Conditional expectation of dealer profit given that the next trader is a seller
= (1-P)(V-B) + P[(V E) - B] = V - B – PE.
Conditional expectation of dealer profit given that the next trader is a buyer
= (1-P)(A-V) + P[A - (V + E)] = A - V – PE.
Since the next trader is equally likely to be a buyer or a seller, the expected dealer profit is
= ½(V – B – PE) + ½(A – V – PE) = ½(A – B) – PE.
Finally, setting ½(A – B) – PE = 0, we obtain A – B = 2PE .

 When uninformed traders use limit orders
•
• Informed traders trade on either the other side or the same side, depending on their private information.
Uninformed traders either regret trading or regret not trading.
 When uninformed traders use market orders
• Pay large spreads (due to informed trading)

 Information asymmetry among traders (+++)
 Time to cancel limit orders (++)
 Volatility (++)
 Limit order management costs (+)
 Value of trader time (+)
 Differential commission between limit and market orders
 Trader risk aversion (+)

 Information asymmetry
 Volatility
•
•
•
Limit order option values increase with volatility
Inventory risks increase with volatility
Asymmetry problem increases with volatility
 Utilitarian trading interest
•
• Utilitarian traders are uninformed - lower adverse selection
High volume stocks have lower order processing costs, smaller inventory risks, more limit order trading, smaller timing option value, and more dealer competition

An example:
 I buy 100 shares of ABC. When I decide to buy the shares, the market is
50 bid, 51 offered. I actually buy at 51.20, paying a $29 commission.
Cash outflow = 5,120 + 29 = 5,149
 When I make the decision to sell, the market is 54 bid, 54.50 offered. I actually sell at 54, paying a $29 commission.
Cash inflow = 5,400 – 29 = 5,371
 My net cash flow is 5,371 – 5,149 = 222. [A return of 4.31%(= 222/5,149)]
 In my paper portfolio, I buy and sell at the midpoint of the bid and ask quotes at the time I decide to trade.
 I buy 100 shares at 50.50 and sell at 54.25 = 375 (a 7.43% return)
 The implementation shortfall is 375 – 222 = 153 (ignoring interest)
 Alternatively, the implementation shortfall is 7.43% – 4.31% = 3.12%

 The cost of a trade is explicit cost + implicit cost
Explicit cost: commission (net of any rebates of goods or services,
“soft dollars”)
Implicit cost: the cost of interacting with the market.
The initial purchase was made $0.70/sh above the BAM, so the implicit cost = $70
The final sale was made $0.25/sh below the BAM, so the implicit cost = $25
 The implicit cost computed with respect to the BAM is the effective cost .
 The effective cost is a useful measure for market orders .

 Effective spread = 2 x effective cost
For the initial purchase, the effective spread
= 2 x $0.70 = $1.40 / share.
Intuition
The quoted (posted) spread is 51 – 50 = 1. If a buyer pays $0.70 above the BAM and sells $0.70 below the BAM, they are effectively facing a bidask spread of $1.40.

 For executed trades, the realized cost is the transaction price relative to the BAM at some time subsequent to the trade.
 This impounds price movements after the trade (including the price impact due to the information in the trade).

 This cost can be interpreted as the profit realized by the other (contra) side (e.g., dealer) of the trade, assuming the contra side could lay off the position at the new BAM.
Example
• The dealer sells to the customer at 100.09.
•
•
• Five minutes later, the market is bid 100.02, 100.12 offered (BAM = (100.02+100.12)/2 = 100.07.)
The realized cost is 0.02.
This would be the dealer’s profit if he could reverse the trade ( purchase the stock) at the subsequent
BAM.

Quoted Spread = (Ask – Bid)
= [(Ask – M) + (M – Bid)], where M = (1/2)(Ask + Bid)
= the midpoint of the bid and ask.
Effective Spread = 2Abs(T – M) = 2D(T – M)
= 2 x Effective Cost , where T = the transaction price,
D = +1 for customer buy order and
-1 for customer sell order.

Price Impact = D(M+ – M).
Price Impact measures decreases in M following customer sells and increases in asset value following customer buys, which reflect the market’s assessment of the private information the trades convey. Such price moves constitutes a cost to market makers, who buy prior to price decreases and sell prior to price increases.
Realized Spread = Effective Spread - Price Impact
= 2D(T – M) 2 D(M+ – M) = 2D(T - M+)
= 2 x Realized Cost
= Market making revenue, net of losses to better-informed traders





Oftentimes traders break up large orders into smaller ones, and feed them to the market over time.
In a sequence of orders, the cumulative price impact means that later orders will trade at worse prices than early ones.
For a buy sequence, the effective cost is:
(volume weighted average purchase price) –
(BAM prevailing at time of trading decision)
Suppose the BAM is 10.00. We buy 100 shares at 10.10,
500 shares at 10.25 and 400 shares at 10.50.
•
• The vol wtd average purchase price is 10.335/share.
The effective cost is $0.335 per share.

 Suppose the BAM = $10.00. We want to buy 1,000 shares.
 The effective cost of one 1,000 share order is $0.30/sh.
 If we split the order into two 500 share trades, we pay
500 x ($10.00 + $0.20) + 500 x ($10.00 + $0.35)

= $10,275
Relative to the initial midpoint, the trading cost is 275
($0.275/sh)

 Statistical tools from time series analysis attempt to correlate orders with subsequent price movements. See Chung et al. (2004)

•
•
•
•
General considerations.
Market impact is not the same for all orders in all markets.
Large orders have higher impact than smaller orders.
Orders perceived as originating from “smart” traders will have high impact.
Orders that execute in markets that cater to retail investors will have low impact.

 For a single limit order there are no summary measures comparable to effective and realized spreads.


Market orders always execute. The only issue is price.
Limit orders often don’t execute.
• How should we account for an order that wasn’t filled?
• What is the cost of a delayed execution?
 It is possible to measure the effective cost of strategies that use limit orders if the strategy ensures an (eventual) execution.



Situation: the trader must fill an order by some pre-set time (like the close of trading).
Strategy
•
•
First use limit orders at (or away from) the market.
If a limit order doesn’t execute within some pre-set time, replace it with a more aggressively priced order.
•
•
Repeat.
If no limit orders have been filled by the end of the day, switch to a market order.

Example: It’s 10am. I have to buy 100 shares by today’s close. The market is 20.50 bid 20.60 offered.
•
•
•
I put in a buy limit order at 20.50.
If the order hasn’t executed in 30 minutes, I’ll cancel and replace with a buy limit order priced at 20.51, etc.
If no fill by the close, I’ll cancel the limit order and submit a market order.

 Fundamental volatility is due to unanticipated changes in instrument values
• Price changes due to adverse selection spread component contribute to fundamental volatility
 Transitory volatility is due to trading activity by uninformed traders

 Interest rates and credit rating (bonds)
 Factors that affect firm value (stocks)
 National inflation rates, macroeconomic policies, and trade and capital flows
(currencies)
 Cash market supply and demand
(commodities)

 Storage costs
High storage costs → small inventories
→ demand shocks → high price volatility
 Perishable goods
 Fundamental uncertainties
• High PE ratios, high political risks, highly leveraged firms

 Arises when the demands of impatient uninformed traders cause prices to diverge from fundamental values.
 These price changes are transitory because prices eventually revert to fundamental values.
 The transaction cost component of the bid-ask spread contributes to transitory volatility (i.e., bid-ask bounce).
 Bid-ask bounce causes negative serial correlation in transaction price changes. See
Roll’s model.