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  • 1. The Organization of Financial Markets Bruno Biais Toulouse School of Economics Rotman School’s Distinguished lecture Series Toronto University January 2008
  • 2. Goal
    • Describe the way orders are matched & prices are formed in major financial markets.
    • Understand mechanics of market process.
    • Be aware of the variety of trading systems across countries & markets.
    • Knowledge necessary for theoretical analysis (extensive form of the game) and empirical studies (where does data come from?)
  • 3. Outline
    • 1) Order driven markets: Limit Orders, Market orders, Call Auction, Continuous Market.
    • 2) Dealer markets
    • 3) Mixed market structures
  • 4. Order driven & quote driven markets London & Nasdaq before 1997, FX, Bonds, Derivatives Frankfurt, London, NYSE, Nasdaq, Matif, Xetra, Eurex (see Euronext, Tokyo, Inet, Hong Kong, Toronto Stock Exchange Only specialist/ market makers/ dealers post quotes As in order driven + specialist or market makers All investors can announce prices at which they want to buy or sell (via brokers) Quote driven markets Mixed/hybrid market structures Order driven markets
  • 5. 1) Order driven markets
  • 6. Limit orders and market orders
    • Limit buy order : I want to buy 100 shares at price no larger than $ 60 per share.
    • Market buy order: I want to buy 100 shares at any price.
    • Limit sell order: I want to sell 100 shares at $ 80 per share or above.
    • Market buy order: I want to buy 100 shares, at any price.
  • 7. The limit order book
    • The limit orders which have been placed, and have not yet been executed, cancelled or revised are collected in the limit order book.
  • 8. A day at the exchange Opening (9:00 CET) Close (5:00 CET) Continuous market Preopening After hours
  • 9. Call auction
    • Used to set the price at the opening of the market (NYSE, London Stock Exchange, Paris Bourse, Frankfurt, Madrid, Milan,Eurex…)
    • All buy orders cumulated: demand function
    • All sell orders cumulated: supply function
    • Price set to maximize trading volume.
    • All buy orders at or above this price filled
    • All sell orders at or below this price filled
  • 10. Cumulated supply Limit orders to sell Cumulated demand How much can be traded at that price = Min[Supply,Demand] Limit orders to buy
  • 11. Volume maximizing price: 260
  • 12. Rationing
    • Because we are working with step functions/discrete pricing grid, at the volume maximizing price supply is not always equal to demand.
    • If that happens rationing on the sell or the buy side. (In our example 5 sales offered at 260 remained unexecuted).
    • Time priority usually applies (First In First Out).
  • 13. Uniform price
    • In this auction all trades are conducted at the same (uniform) price.
    • Limit buy orders at price 355 are filled at the equilibrium price: 260
    • Limit sell orders at price 150 filled at 260
    • If many traders, each has little impact on price: price at which limit order is placed mainly influences its execution probability (not the price at which it is filled).
  • 14. Preopening tâtonnement
    • Not easy to find the opening price (news, overnight order flow, how to react to Tokyo ’s close, etc…)
    • To help traders figure out this, exchanges (Xetra, Toronto, Euronext, Madrid, …) allow for order placement an hour before opening.
    • Indicative preopening prices computed as traders place, revise, cancel orders (no trade at these prices).
  • 15. Does preopening period help?
    • Could help coordinate expectations, advertise liquidity demand.
    • But since orders can be withdrawn, they could be purely manipulative. Then preopening indicative prices would be pure noise.
    • Biais, Hillion, Spatt ( Journal of Political Economy , 1999): empirical study of preopening period in Paris Bourse. Preopening indicative prices do convey useful information, especially in the last 10 minutes..
  • 16. After the opening
    • Executed buy and sell orders are no longer in the book. Unexecuted buy orders (placed at price below the opening price) and sell orders (placed above the clearing price) remain in the book.
    • Best offer to sell: ask price, best bid to buy: bid price. Difference: bid-ask spread. Quantity offered at the ask: depth at the ask, quantity at the bid: depth at bid.
  • 17. All the limit sell orders placed above 260 are filled All limit buy orders placed at or above 260 are filled
  • 18. Best bid: 250 Best ask: 260 Depth at Best ask: 5 shares Depth at best bid: 5 shares
  • 19. Visibility of order book
    • In Xetra, Euronext, or Inet several orders on each side of the book are visible on traders ’ screens. Orders further away from the quotes are not visible. [If you want to see live order book go to great stuff]
    • Until 2002, on the NYSE only the specialist saw the orders in the book. Since 2002: NYSE open book. Traders off the floor can electronically observe the order book.
  • 20. Inet Order Book, Dell, April 19 2006
  • 21. The continuous market
    • Investors can place new market or limit orders in the book or cancel limit orders that have not been filled or trade against limit orders present in the book.
    • If more than one order are present at a given price time priority applies.
    • Opening: multilateral trading, many investors participate in opening trade.
    • Continuous market: bilateral, match one buyer and one seller.
  • 22. Example
    • 9:00: 5 shares are offered at the best ask (260), 5 more at 270.and 5 shares are demanded at the best bid (250).
    • 9:05: market order to buy 2 shares; immediately filled at price 260. Bid-ask spread remains the same but depth at the ask reduced.
    • 9:06: limit order to buy 10 shares at 255, spread reduced to (260-255).
    • 9:10: Market order to buy 5 shares.
    p t 260 250 9:00 9:05 9:06 Ask Bid 255 T
  • 23. Order flow dynamics
    • Biais, Hillion & Spatt, Journal of Finance , 1994.
    • After large purchases ask & bid quotes shifted upward.
    • When spread large, limit orders within quotes frequent.
      • When depth at quotes limited, limit orders at quotes frequent.
      • When spreads tight & depth large, market orders frequent.
    • Order types positively serially autocorrelated:
      • Large orders follow large orders.
      • Buy orders follow buy orders.
      • Market orders follow market orders.
  • 24. Order dynamics in Toronto Stock Exchange
    • Griffiths , Smith, Turnbull & White , Journal of Financial Economics , 2000.
    • Aggressive buy (sell) orders tend to follow other aggressive buy (sell) orders
    • They occur when bid–ask spreads are narrow and depth on the same (opposite) side of the limit book is large (small).
    • Aggressive buys are more likely than sells to be motivated by information.
  • 25. Technology
    • Until 80s, most stock and futures markets based on floors, while Nasdaq, the London Stock Exchange, and bond, OTC & currency markets telephone based.
    • Since 80s, trend towards electronic computer based trading platforms: Euronext, Eurex, Xetra, LSE, Nasdaq, Toronto.
    • Lower processing costs, greater ability to disseminate info & connect to the market, level playing field/less adverse selection.
    • But NYSE & US futures markets still to some extent floor based (unlike Europ stocks & futures).
  • 26. Best execution and price priority
    • Price priority: If someone offered to sell at 260 (for example by placing an order in the book) then broker receiving an order to buy cannot execute it at a higher price : Broker must seek best execution.
    • Priority rules easier to enforce if transparent markets & information widely disseminated; even easier if centralized computerized order book.
    • Why price priority? To prevent brokers from ripping off customers, to incentivize investors to place bids in line with their valuation of the asset.
  • 27. Liquidity demand and supply
    • Traders placing market orders demand immediacy, they want rapid execution: they demand liquidity
    • Traders placing limit orders stand ready to trade with incoming market orders: they supply liquidity.
    • Intermediaries acting as market makers by placing limit orders: earn spreads.
    • Investors willing to delay execution to lower cost of trading: avoid paying spreads.
  • 28. 2) Dealer markets
  • 29. Quote driven markets
    • Dealer markets are quote driven: only certain players (have the right to) post bid and ask quotes and thus supply liquidity: Forex market, OTC, US futures markets, … These players are called market makers or dealers
    • Obligations: to post quotes, limit on spread, minimum on quantity, reporting requirements.
    • Privileges: right to post quotes, information about order flow and book, lower or no fees paid to the exchange.
  • 30. Dealers’ revenues and costs
    • Revenues: Dealers try to buy low (bid) & sell high price (ask). Earn bid-ask spread.
    • Costs:
      • Between purchase & sale, hold security in inventory: Risk bearing cost/inventory cost.
      • If, market buy followed by price increase, loss for dealer. Arises if market orders placed by informed agents. Adverse selection cost.
    • Competitive dealers: Bid-ask spread = compensation for inventory costs & adverse selection costs.
    • Market power: spreads also reflect rents
  • 31. Why could dealership make sense ?
    • 1) Fixed cost to provide liquidity: link with electronic system, stay on floor; acquire information.
    • Efficient to spread this cost over many trades. That’s what professional market participants (dealers & market makers) do. Thus, the final investors participating infrequently to the market do not incur this fixed cost.
    • 2) It takes initial liquidity to attract orders (priming the pump) & dealers can help coordinating expectations about liquidity.
  • 32. Potential drawbacks
    • If only small group of market participants allowed to supply liquidity, risk of collusion. Tents at expense of outsiders.
    • Nasdaq before 1997. Christie and Schultz ( Journal of Finance , 1994): Nasdaq dealers traded only even eighths. After CS’s article & Wall Street Journal sudddenly use odd eighths.
    • SEC Order Handling rule (1997): Limit orders must be displayed + internet technology: ECN run electronic limit order book. Investors compete to supply liquidity: Spreads narrow.
  • 33. An important dealer market: the Forex market Customer Customer Bank Bank Bank Today/yesterday (EBS): Observe quotes Post quotes Customer Customer Bank Bank Bank Tomorrow? (FXAll. Online FX only about 1% of total): Observe quotes Post quotes
  • 34. Interdealer trading
    • When one customer trades only with one dealer, the latter rebalances its trades with other dealers.
    • When customers can spread their trades between several dealers, less need to rebalance trades.
    • Empirical prediction: as forex market switches to internet trading systems, trades between customers and dealers will grow relative to interdealer trading.
  • 35. Comparing order driven & quote driven Customer Customer Dealer Dealer Dealer Observe quotes Post quotes Forex tomorrow or LSE yesterday: Customer Customer Dealer Dealer Observe quotes Post quotes LSE today:
  • 36. 3) Mixed market structures
  • 37. Mixed market structure
    • Investors placing limit orders along with professional market makers stand ready to serve orders to buy or sell & provide immediacy.
    • NYSE: as in order driven markets investors can enter limit orders in the book; in addition specialists manages the book, can enter his/her own orders. Must “maintain an orderly market.”
  • 38. NYSE Investor Investor Investor Investor Electronic Limit Order Book Electronic order submission Electronic order submission Specialist Broker Broker Manual order Face to face interaction
  • 39. Who Trades on the NYSE? (Source Moulton, 2006) Most orders and trades are electronic. For small stocks specialist intervenes more, brokers less.
  • 40. Who Trades with Whom on the NYSE? (Source Moulton, 2006) Most trades involve electronic orders on one or both sides. Percentage pretty stable across stocks.
  • 41. Advantages of this dual system
    • Investors can place limit orders, and thus compete to supply liquidity, especially since 2002, NYSE open book.
    • Specialist constantly monitors market, intervenes to supply liquidity if transient mismatch (intertemporal intermediation.)
    • Long term relationship between brokers and specialists: reputation effects can mitigate adverse selection problems.
  • 42. Drawbacks
    • Until 2006, direct access to electronic system (NYSE Direct +) limited: Order size < 1099 shares. Not more than one order per 30 seconds.
    • NYSE rules allow brokers on the floor to violate time priority of orders in the book, stepping in before order is hit.
    • Competition between floor and electronic book biased: adverse selection problem for floor.
  • 43. Hybrid market
    • Approved by SEC March 2006. Lift restriction on Direct + orders: 1099 shares and 30 secs.
    • Investors who want direct and immediate execution against the order book can request it: “NX.” NX orders can “sweep” the book.
    • Investors who prefer to allow specialist or broker to step in can request it.
    • These new rules make NYSE more similar to European electronic limit order books, while keeping some of the advantages & drawbacks.
  • 44. Brokers in hybrid market
    • Brokers can electronically place limit orders in the book: “e-quotes.”
    • Brokers can choose to hide these orders or make them visible (// Euronext or Inet.)
    • Only brokers can hide orders (way to preserve some of the franchise of brokers.)
    • Specialist can see aggregate amount of hidden orders but not details (way to preserve specialist’s franchise.)
  • 45. LRPs in hybrid market
    • Liquidity replenishment points.
    • When large price change: If individual order moves stock price by > 9 cents. Or if stock price moves by > 25 cents or 1% price in 30 secs.
    • Maybe due to transient lack of liquidity.
    • Automatic execution halted. Specialist tries to elicit liquidity supply. Automatic market starts again after manual trade or 10 secs.
  • 46. LRP Tradeoffs
    • Pros: LRP maybe triggered by transient lack of liquidity: lots of relatively uninformed buy orders, liquidity demand exceeding depth in the book, optimal to advertise this imbalance & call for liquidity supply.
    • Cons: Automatic execution halted, specialist and floor brokers find out if sudden flow of market order was uninformed. If it was, provide liquidity. Otherwise execute against book. Adverse selection problem for book.
    • Solution: Run electronic auction with equal access to floor & electronic traders?
  • 47. Conclusion
    • Trend in equity markets (and also other markets such as government bonds or forex): Electronic limit order books. NYSE was able to resist this trend for a long time because of its quasi monopoly position. European Exchanges, which competed against one another had to move earlier.
    • Trend much less clear in other markets, especially bond market. There OTC dealership prevails. Why? Is this going to last? What are the consequences?