2. Modern financial markets
2.1 US equity markets
The main US primary markets are the New York Stock Exchange (NYSE)
and NASDAQ.
What is primary market?
There are also several US regional exchanges. Regional exchanges were
created primarily to list local companies that could not afford to become
listed in the national exchanges. Current regional exchanges include
Boston, Chicago, Pacific, and Philadelphia exchanges.
Boston and Philadelphia regional exchanges were acquired by NASDAQ in
2007. One of the primary markets, American Stock Exchange, was acquired
by NYSE Euronext in 2008. In 2013, ICE bought NYSE Euronext.
Two ECNs, BATS and Direct Edge, have become exchanges in 2008 and
2010, respectively.
.
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2. Modern financial markets
2.2 The New York Stock Exchange (NYSE)
The NYSE was founded as an open-outcry auction in the end of the
18th century and has evolved since then into a complex hybrid
market combining an open outcry with a quote-driven (dealer)
market and electronic LOB.
For every stock traded on the floor, there is a designated dealer
(specialist) who maintains the LOB and makes the market using his
own account when there is lack of liquidity from other traders.
Another specialist’s duty is conducting the opening and closing
auctions.
Specialists are not allowed to trade ahead of their customers at the
same price on the same side of the market. In fact, trading by
brokers and dealers for their own account using the knowledge of
their customers’ pending orders (so-called front running) is illegal.
2
3
The New York Stock Exchange (NYSE)
4
2. Modern financial markets
2.2 The NYSE (continued)
In 2007, the NYSE introduced the Hybrid Market system. Traders now can
directly submit their orders to the electronic LOB bypassing brokers and
specialists unless their order size exceeds one million of shares.
The reasons:
- customers have more choices and faster execution
- growing trading volume requires automatic execution
- SEC has issued the new rule (Regulation NMS Order Protection Rule),
which requires the market to honor better-priced quotes available in other
“fast” markets before filling orders at the market’s own prices. Sub-second
order execution is required for the status of “fast market”, which is
accomplished by introduction of the Hybrid Market.
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2. Modern financial markets
2.2 The NYSE (continued 2)
Market orders and marketable limit orders in the Hybrid Market are by
default executed automatically. There are however stock-specific price
ranges (so-called Liquidity Replenishment Points) that determine the limits
for price jumps and volatility. If these limits are reached, trading is converted
from automatic to “auction only” execution.
Introducing the Hybrid Market has reduced an average execution time from
10 seconds to less than one second. This, however, increased the bid/ask
spread (i.e. cost of immediacy) by about 10% (Hendershott & Moulton
(2010)).
In 2007, the NYSE was merged with the pan-European electronic market
Euronext into NYSE Euronext. November 2013, ICE completed takeover of
NYSE.
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2. Modern financial markets
2.3 NASDAQ
NASDAQ was founded by National Association of Securities Dealers
(NASD) in 1971. In 2007, NASD was consolidated with the member
regulation, enforcement and arbitration functions of the NYSE into the
Financial Industry Regulatory Authority (FINRA), which is the largest
independent regulator for all securities firms in the United States.
NASDAQ is a purely electronic market: it does not have a physical floor,
and its dealers and brokers are connected via electronic network. The
specific of NASDAQ is that several competing dealers can trade stocks of
the same company (rather than one specialist in the NYSE).
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NASDAQ
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2. Modern financial markets
2.4 Alternative trading systems (ATS)
ATS are regulated by the SEC but are not registered as exchanges.
Hence ATS cannot list new securities. ATS serve as alternative
sources of liquidity and compete with exchanges for customers
using lower execution latency and fees. There are two main types of
ATS: electronic communication networks (ECN) and crossing
networks (dark pools).
2.4.1 ECN
ECN have electronic LOB and trading rules similar to those in
continuous order-driven markets. They often permit only limit orders
and offer possibility to trade before and after regular trading hours.
Most ECN have been acquired or merged with exchanges, e.g. one
of the first ECN, Instinet, was bought by NASDAQ in 2006 and ECN
Archipelago was merged with the NYSE in 2006. BATS Exchange
and Direct Edge were founded as ECN (in 2005 and 1998,
respectively) but became exchanges in 2009 and 2010, respectively.
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2. Modern financial markets
2.4 Alternative trading systems (continued)
2.4.2 Crossing networks (CS)
There is no price discovery in CS where orders are matched upon prices
quoted in the primary markets. Trading in CS has no explicit market impact.
The first CS (ITG, Liquidnet, and Pipeline) offered anonymous block trading.
Average trade sizes in these venues reach tens of thousands shares.
Other CS have been implemented by several large brokers for
internalization of their customers’ orders. In these CS, brokers can trade for
their own account against their customers and typical order size is several
hundred shares. These CS include Credit Suisse Crossfinder, Goldman
Saks Sigma X, GETCO Execution Services, and Knight Link. In July 2013,
GETCO and Knight completed merger.
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2. Modern financial markets
2.5 European equity markets
Major markets: London Stock Exchange and Deutsche Bourse.
Markets in Financial Instruments Directive (MiFID) in 2007:
- pre- and post-trade transparency (aggregated LOB, volumes)
- best execution (across borders)
Pan-European ATS (called in Europe the Multilateral Trading
Facilities (MTF)): Chi-X (in 2009 volumes exceeded those of Madrid
and Swiss stock exchanges), BATS Europe, Turquoise, several US
ATS.
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2. Modern financial markets
2.6 Global FX market
2.6.1 Introduction
Most liquid market: ADV has grown from $3.3 trillion to $5.3 trillion between
2007 and 2013.
Centers: London, New York, Tokyo;
also: Singapore, Australia, Canada.
Main currency pairs: EUR/USD, USD/JPY, GBP/USD.
Also: USD/AUD, USD/CAD, USD/CHF, EUR/JPY, EUR/GBP, EUR/CHF.
Proxies to equities/commodities (?)
pips
Exchange rate (EUR/USD):
1.3456(5)
decimal pip
big figure
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2. Modern financial markets
2.6 Global FX market (continued)
2.6.1 Introduction (continued)
Difficult to estimate fair value…
-Purchase power parity
-Interest rates
Why trade then? Import/export cash flows, hedging, speculation
FX is OTC market: little international regulation
2.6.2 Spot FX
Trading one currency for another with delivery usually taking place
within two days after the dealing date (but USD/CAD – one day).
The share of spot FX in the ADV in 2010 is estimated between 37%
worldwide and 55% in the USA.
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2. Modern financial markets
2.6.2 Spot FX (continued)
Interdealer platforms: EBS (owned by ICAP) & Reuters-Thomson
-
Limit orders only
Credit screening
Prime bank business model
Distributed architecture (EBS)
Dealer-to-client platforms
- multi-dealer platforms (Currenex, HotSpot, FXall)
- bank portals (Citi, Deutsche)
- retail brokerages (FXCM, Gain)
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2. Modern financial markets
2.6.3 Other FX instruments (Dodd-Frank -> SEF)
FX swap is a contract that simultaneously agrees to buy (sell) an amount of
currency at agreed rate and to resell (repurchase) the same amount of
currency for a later date to (from) the same counterparty, also at agreed rates
(44% worldwide and 31% in USA) .
Outright forward is a contract to exchange a predetermined amount of one
currency for another at an agreed date in the future, based upon a rate of
exchange determined at the trade date of the contract (~13%).
FX option is a contract that gives the buyer the right, but not the obligation, to
exchange one currency for another at a predetermined exchange rate on or
until the maturity date.
NDF is similar to outright forward but there is no physical settlement of two
currencies at maturity. Rather, based on the movement of two currencies, a net
cash settlement will be made by one party to the other – usually in US dollars.
In currency swap, interest and principal in one currency are exchanged for
interest and principal in another currency.
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2. Modern financial markets
2.7 US fixed income market
Instruments: UST, money market, ABS, MBS, agencies (Fannie Mae),
municipal bonds.
Interdealer brokers: Brokertec (owned by ICAP), eSpeed (owned by the
BGC Partners), and Tradeweb (owned by several financial institutions
with Reuters-Thomson having a majority stake).
“Workup” (expandable limit order)
27
Price in
90.27 (90-27) = 90
32
27
1
Price in 256th: 90.27+ = 90
+
32 64
32nd:
27
3
90.273 = 90
+
32 256
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2. Modern financial markets
2.7 High-frequency trading (HFT)
Portfolio turnover from seconds to hours
HFT => technology (microwave?) + co-location
Leveling the field: IEX’s “speed bump”, MQL, randomization of LOB
2.7.1 HFT strategies:
- market making (rebates)
- statistical arbitrage
- event/news arbitrage
- slicing large orders (algorithmic trading)
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2. Modern financial markets
2.7 High-frequency trading (continued)
2.7.2 HFT controversies
- unregulated liquidity source (flash crash of 2010)
high volume != high liquidity (“hot potato” effect)
circuit breakers (10% price fall within 5 min => 5-min pause)
Toxic trading:
- sponsored (naked) market access (banned in Nov 2010)
- stub quotes (banned; deviation from national best less than 8%)
- quote stuffing (submitting lots of orders)
- quote spoofing/layering (submitting orders for provoking price
change)
-pump and dump (pushing price of illiquid instrument by small
orders)
-pooling (two traders trade among themselves at artificial prices)
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Materials about HFT
•
http://tabbforum.com/opinions/hft-in-search-of-thetruth?page=3&utm_campaign=36d190f832-UA-121603921&utm_medium=email&utm_source=TabbFORUM+Alerts&utm_term=0_29f4b8f8f136d190f832-272896141
•
https://www.youtube.com/watch?feature=player_embedded&v=ItfAKguEdAE#at=63
•
http://www.birs.ca/events/2013/5-day-workshops/13w5008/videos
•
http://www.amazon.com/Problem-HFT-Collected-FrequencyStructure/dp/1481978357/ref=sr_1_1?s=books&ie=UTF8&qid=1384719035&sr=11&keywords=bodek
•
http://www.amazon.com/Flash-Boys-MichaelLewis/dp/0393244660/ref=sr_1_1?s=books&ie=UTF8&qid=1419256380&sr=11&keywords=flash+boys
•
http://www.amazon.com/Flash-Boys-Insiders-Perspective-HighFrequency/dp/0692336907/ref=tmm_pap_title_0#customerReviews
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