Introduction and Market Microstructure Data Prof. Ingrid M. Werner Spring 2004
What is market microstructure?
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.
What is Market Microstructure?
Maureen O’Hara: “Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.”
It is one of the most rapidly growing areas in Finance.
It has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.
Vignette WFA Sunriver, OR, 1996
Distinguished speaker Prof. Joseph Williams UBC “The problem with Finance is that we have lost touch with the business world and the needs of those who are supposed to apply our theories.”
Comment by Prof. Maureen O’Hara, Cornell “He obviously does not follow the field of market microstructure…”
Market microstructure is probably the area in Finance with the closest ties to practice.
Conferences draw a steady crowd of practitioners, regulators, lawyers, and computer scientist who pay “exorbitant” conference fees to hear academics present thei research findings!!!
Market centers have made transactions data available to researchers
NYSE, Nasdaq, Regionals, Island (INET)
Paris Bourse, London Stock Exchange, Toronto Stock Exchange, Tokyo Stock Exchange, Hong Kong Stock Exchange, Korea Stock Exchange, …
CBOE, ISE, CME, etc.
Ohlsen Associates, Reuters
Market centers have also provided generous research support.
NYSE Visiting Academic Fellow
NYSE Day on the Floor Program
Nasdaq Visiting Research Economists
Frank Hatheway and Tim McCormick
Regulators actually listen!
Believe it or not, this is a field where the regulators actually listen to the advise of academics!
Manning Rules (1994, 1995)
Concept Release (1999, Richard Lindsey)
Regulation ATS (1999)
Decimalization (2000-2001, Larry Harris)
Rule 11Ac1-5, Rule 11Ac1-6 (2001, Mark Ready)
Regulation NMS (2004, Larry Harris)
Round table discussions
Why do they care?
Data guided by theory, Theory guided by data
Efficiency – welfare issues
Is insider trading bad?
Market design issues
Agency auction market
Electronic limit order books
Market performance issues
Competition for order flow
What is in it for me?
Given the amount of research in the area, it still surprises me how limited our knowledge is of different market structures.
This is good news!!!
There is plenty of room for more research!!!
This course will cover only the basics.
I will try to point you in the direction of fruitful areas for research as we go along.
Who am I?
Instructor: Prof. Ingrid M. Werner
At OSU since 1998
Prior to that, at Stanford Business School (1990-1998)
PhD economics from University of Rochester (1990) and MBA from Stockholm School of Economics (1984)
Visited NYSE 1997
Visited Nasdaq 2001-2002
Introduction and market microstructure data.
Market making and inventory control
Asymmetric information and strategic trading
Block trades and institutional trading costs
Limit order books and order submission strategies
Estimating structural microstructure models (PIN), modeling irregularly spaced data (ACD), linking microstructure to asset pricing, event studies, etc.
The market for NYSE stocks today broker-dealers public investors SEC U.S. markets direct access non U.S. markets Instinet 10 ECNs NASD broker dealers ARC NYSE CSE PHLX CHX BSE ITS Knight Madoff Liquidnet Millennium HarborSide Posit Crossing Network Source: Goldman Sachs, Trading & Market Structure Analysis
Volume distribution - NYSE stocks Source: Goldman Sachs Trading & Market Structure Analysis Seeing through Nasdaq InterMarket
Single-counted, share volume
Internal matches only
Major international stock markets
London Stock Exchange (LSE)
Deutsche Borse (DB)
Milan Stock Exchange
Swiss Stock Exchange (also Virt-X)
Tokyo Stock Exchange (TSE)
Taiwan Stock Exchange
Korean Stock Exchange
Australian Stock Exchange (ASX)
Hong Kong Stock Exchange
Toronto Stock Exchange (TSX)
US bond markets
Corporate and government bonds trade OTC in wire houses.
Inter-dealer brokers often organize markets.
E.g., Cantor Fitzgerald (eSpeed)
NYSE- and AMEX-listed corporate bond markets are very small.
US Derivatives markets
US Equity options
Securities and Exchange Commission (SEC)
Securities markets, equity options markets, and cash-settled equity index options markets
Commodity Futures Trading Commission (CFTC)
Commodity spot, forward, and futures markets
The SEC and the CFTC write regulations to interpret and implement the laws that fall into their jurisdiction
They also collect and disseminate information
Additional regulators include: the Federal Reserve Board (Reg. T margins), state-specific SECs, SROs, FASB, AIMR, IOSCO, WFE, and ICSA…
A Primer on Orders
What are orders?
Orders are instructions that traders give to the brokers and exchanges which arrange their trades.
Instrument (or instruments) to trade.
How much to trade.
Whether to buy or sell.
Partial or fill-or-kill
Where to present the order
How to search for other side
Who uses orders?
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.
At a disadvantage vis-à-vis professional traders.
Risk of misunderstandings
Conflicts of interest
Speed of reaction to changing market conditions
Cancellations can be time consuming
Access to order flow information
What are bids and offers (asks)?
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, fourchette, vigorish…)
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.
What are agency/proprietary 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.
Agency orders can be held or not held/worked.
Held orders are those when the broker has an obligation to a client to fill the order.
Market-not-held orders are institutional orders where the trader hires a broker-dealer to execute the order.
Working an orders means that a broker-dealer takes some time to fill the order.
A market order is an instruction to trade at the best price currently available in the market.
Buy at ask/sell at bid => pay the bid/ask spread
Suppose the quotes for ABCD are a bid of $50.00 and an offer of $50.50, what is the transactions costs for a trader using a market buy order in ABCD?
What is the best estimate of the value of ABCD?
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 looses from price improvement?
Should it be allowed to offer price improvement?
Should everyone be allowed to offer price improvement?
Does your answer depend on the minimum price increment in the market?
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.
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.
Prices might move further following the trade.
Information and liquidity reasons.
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.
OK to trade at or above the limit sell price.
OK to trade at or below limit buy price.
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.
Limit order placement Behind the market Away from the market Below the best bid At the market At the best bid In the market Between the best bid and offer Marketable At the best offer Marketable (aggressive) Above the best offer Buy orders Limit price placement
Limit orders are trading options
Limit orders offer other traders an option to trade, that is they supply liquidity.
Sell limit orders are call options that give traders the right to buy.
Buy limit orders are put options that give traders the right to sell.
What is the option strike price?
How are limit orders different from regular option contracts?
On what factors does the value of the option to trade depend?
How do these factors impact the bid ask spread?
Why would anyone use limit orders?
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?
Other order types
A stop instruction stops an order from executing until price reaches a stop price specified by a trader.
Buy only after price rises to the stop price.
Sell only after price falls to the stop price.
Can be either stop market or stop limit orders.
How are stop limit orders different from regular limit orders?
How do stop orders affect liquidity?
Market-if-touched orders become a market order when price reaches some preset touch price.
Buy when market falls to the touch price.
Sell when market rises to the touch price.
How are MIT orders different from regular limit orders?
Do MIT orders demand or supply liquidity?
Traders who want to condition their orders on the last price change submit tick-sensitive 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?
All-or-nothing, and minimum acceptable quantity instructions
Special settlement instructions
How do these affect the cost of trading?
The trading rules and the trading systems define a market’s market structure.
Call markets versus continuous markets.
Call markets allow trades only when the market is called (rotation among securities).
Continuous markets allow trades anytime during regular trading hours.
Hybrids of course exist (NYSE, the LSE and soon Nasdaq)
Which one would you prefer, and why?
Most markets limit their regular trading hours.
Should markets be open around the clock?
Dealers supply the liquidity
Dealers participate in every trade
Dealers may trade with each other (interdealer trading).
Why would dealers need to trade with each other?
How should a customer or broker decide which dealer to approach to trade?
Examples of quote-driven markets
The Nasdaq Stock Market, Inc.
The London Stock Exchange (less liquid stocks)
eSpeed government bond trading system
Reuters 3000 foreign exchange dealing system
Rule based order handling and trading
Order precedence rules
Trade pricing rules
Single price (calls), continuous two-sided auctions, crossing networks
Can a dealer trade in an auction market?
Examples of order-driven markets include:
Stock and options exchanges
Markets for new issues of government debt
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
Examples of brokered markets include:
Block trading (stocks and bonds)
Market information systems
It is of utmost important that orders are not lost and that order instructions are understood.
Order routing systems
Order presentation systems
The information created by trading is valuable.
Market data systems report trades to the public
Price and sale feeds
Transparency is a key feature of markets.
Ex ante vs. ex post transparency
Limit Order books versus Call Markets
Order Driven Markets
Trading rules based markets.
Single price auctions
Continuous electronic auctions
The most popular form for new markets.
Order precedence rules match buyers to sellers.
Trade pricing rules price the resulting trades.
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
Open outcry rule
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?
Order precedence rules
Should a trader be allowed to bid below the best bid, above the best ask in an oral auction?
Time precedence (futures markets)
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, time precedence (stock markets)
Why do you think this is necessary?
Trade pricing rule
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.
Rule-based order-matching systems
Used by most exchanges, some brokerages, 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.
Rule-based order-matching systems
Order precedence rules.
Market orders always rank above limit orders…
Strict time precedence
Floor time precedence to first order at price.
All subsequent orders at that price have parity
Why do markets use display precedence?
Some markets give precedence to small orders, other markets favor large orders (NYSE).
Why would a market give precedence to large orders?
Example – Pure price-time precedence $20.05 $20.10 200 200 Buy Sell Bill Seth 12:27 12:27 $20.08 500 Buy Bev 12:25 $20.12 500 Sell Sandy 12:24 $20.08 100 Buy Bob 12:21 Infinite 200 Buy Ben 12:20 $20.08 300 Sell Susie 12:16 $20.06 500 Buy Bern 12:15 $20.06 200 Sell Steve 12:06 $20.05 100 Sell Sammy 12:02 Price Size Buy/Sell Trader Time
Example – the order book Ben 200 Infinite $20.12 500 Sandy $20.10 200 Seth Bev 500 $20.08 300 Susie Bob 100 $20.08 Bern 500 $20.06 200 Steve Bill 200 $20.05 100 Sammy Trader Size Price Size Trader Buyers Sellers
Clearing the order book with a call at 12:30 Ben 200 0 Infinite $20.12 500 Sandy $20.10 200 Seth Bev 500 200 $20.08 300 0 Susie Bob 100 $20.08 Bern 500 $20.06 200 100 0 Steve Bill 200 $20.05 100 0 Sammy Trader Size Price Size Trader Buyers Sellers
Trades in the example - call $20.08 300 Susie Bev $20.08, $20.06 100 Steve Bob Infinity, $20.06 100 Steve Ben Infinity, $20.05 100 Sammy Ben Price? Quantity Seller Buyer
Example – the order book after the call $20.12 500 Sandy $20.10 200 Seth Bev 200 $20.08 Bern 500 $20.06 Bill 200 $20.05 Trader Size Price Size Trader Buyers Sellers
Example - What should be the price/prices?
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.
Uniform pricing rule
All trades take place a 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.
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.
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.
Supply and Demand
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.
Example: Demand and Supply
Discriminatory Pricing Rule
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.
We will use this data for Project II MSFT (7/2002)
144 NYSE stocks from size deciles
Nov 1, 1990 – Jan 31, 1991
We will use this as an example of data from an electronic limit order market.
Build limit order book
Create inside quotes
Ticker Date Time Price Volume Put-through Seq
A=Buy V=Sell Order ref Begin date End date Chaining code Entry date Entry time Order size Discl. Size 0=limit, 1=at market, 2=opening, 3=best, 9=not sign. Price J=EDO, D, R=GTC, L=GTC, E=FOK J=EDO, D, R=GTC, L=GTC, E=FOK
Agency auction/ floor: NYSE
One designated MM/stock, 9 specialist firms.
Specialist participation rate is less than 20%.
Handles 85% of orders, of value
Floor brokers manually trade orders
Represent roughly 50% of value traded
Crowd = floor brokers and specialist
Upstairs facilitated trades
Specialists’ affirmative obligations
Specialists are traders of last resort.
Have to quote firm two-sided markets during trading hours.
Specialists have an obligation to smooth prices by intervening to prevent large price reversals (provide price continuity).
Expensive if informed traders in the market.
Profitable if liquidity is low because other traders are distracted.
Exchanges regularly evaluate specialists based on the width of their quotes, the depth at their quotes, and price continuity.
Liquidity when there are order imbalances
Limit order display
Supposedly stabilize prices
Specialists also do…
Specialists represent system order flow.
Orders that are routed electronically to the exchange for execution.
Specialists get compensated for this service in the form of commissions (for orders that stay on the book (NYSE>5 min)).
Specialists also work orders entrusted to them by floor brokers (CAP, go-along orders).
Specialists act as bulletin boards.
Specialists have a responsibility to make sure that all traders follow the exchange rules.
Conduct an orderly market.
Specialists can engage in:
Speculative trading on their own account.
Observe broker IDs for incoming orders…
Strategies to take advantage of stop orders
Specialists control the quotes
Limit display to top-of-file
Constrained by order exposure rules
Specialists can stop incoming marketable orders.
Specialists conduct the open.
Specialists receive brokerage commissions for system orders.
Specialists have a unique information advantage that they can use to generate dealer profits.
Specialists’ negative obligations
Abide by order preference rules, including public order preference.
Public liquidity preservation principle is typically enforced at primary exchanges.
Specialists can trade only with incoming marketable orders.
Third market dealers and regional specialists are generally not subject to the public liquidity preservation principle.
Dealers’ benefit of trading against stale limit orders is somewhat offset by limit order price protection guarantees.
Dealer market Nasdaq/Seaq
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.
Market maker obligations
Provide quotes during trading hours
Offer “best execution”
Report trades in a timely manner
Electronic Trading Platforms
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