Order driven & quote driven markets London & Nasdaq before 1997, FX, Bonds, Derivatives Frankfurt, London, NYSE, Nasdaq, Matif, Xetra, Eurex (see www.eurexchange.com) 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
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But since orders can be withdrawn, they could be purely manipulative.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..
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 http://data.inetats.com/ds/tools/charts 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.
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.
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.
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.
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.
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
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?
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?