Market Market MicrostructureMicrostructure-Why do prices rise?-Why do prices rise?- Because there are more buyers - Because there are more buyers than sellers!than sellers!

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PlanPlan

Why is the organization of trading Why is the organization of trading process important for investors?process important for investors?

Buying and sellingBuying and selling– Short salesShort sales– Margin and leverage effectMargin and leverage effect

Classification of financial marketsClassification of financial markets– Primary vs secondary marketsPrimary vs secondary markets– Exchange vs OTC marketsExchange vs OTC markets

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ExamplesExamples

TicksTicks– 1/8 vs 1/32 vs decimal1/8 vs 1/32 vs decimal

Price over 100Price over 100– Stock splitsStock splits

Analyst recommendationsAnalyst recommendations– Conflict of interestsConflict of interests

Failure of LTCMFailure of LTCM

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Market participantsMarket participants

BrokersBrokers– Trading on behalf of a clientTrading on behalf of a client

DealersDealers– Trading for their own accountTrading for their own account

Market-makersMarket-makers– Providing bid-ask quotesProviding bid-ask quotes

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Placing an orderPlacing an order

Market Market LimitLimit Short saleShort sale

– ‘‘Selling a cow, which you don’t own’Selling a cow, which you don’t own’– Borrow a stock from (another client Borrow a stock from (another client

of) your brokerof) your broker Stop loss/buy Stop loss/buy

– Conditional market order: to lock in Conditional market order: to lock in gainsgains

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Margin tradingMargin trading

Initial / maintenance marginInitial / maintenance margin– % of MV(assets) kept in the account as % of MV(assets) kept in the account as

collateralcollateral– The rest is borrowed from the brokerThe rest is borrowed from the broker

Margin callMargin call– If the amount in the account drops below If the amount in the account drops below

maintenance marginmaintenance margin Leverage effect: Leverage effect:

r = (ΔP - interest) / (Pr = (ΔP - interest) / (P00margin)margin)

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Classification of Classification of financial marketsfinancial markets Bank creditsBank credits

– Commercial vs Interbank Commercial vs Interbank Foreign exchange (FX)Foreign exchange (FX)

– Spot / forward exchangeSpot / forward exchange– Deposit-loanDeposit-loan

• National marketsNational markets• Euro marketsEuro markets

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Classification of Classification of financial markets (2)financial markets (2) Security marketSecurity market

– PrimaryPrimary– SecondarySecondary

• Exchange: Exchange: – NYSE, LSE (stocks)NYSE, LSE (stocks)– CBOT, LIFFE (derivatives)CBOT, LIFFE (derivatives)

• OTC (over-the-counter)OTC (over-the-counter)– NASDAQNASDAQ

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Desirable Desirable characteristicscharacteristics Informational transparencyInformational transparency Min transaction costsMin transaction costs LiquidityLiquidity

– Ability to open or close large positions Ability to open or close large positions without strong effect on priceswithout strong effect on prices

– Tightness / depth / resiliencyTightness / depth / resiliency Informational efficiencyInformational efficiency

– Speed of incorporating information to Speed of incorporating information to pricesprices

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Market architectureMarket architecture

Degree of continuityDegree of continuity– Periodic vs continuous systemsPeriodic vs continuous systems

Reliance on market makersReliance on market makers– Auction / order-driven marketAuction / order-driven market– Dealer / quote-driven market: market Dealer / quote-driven market: market

maker takes the opposite side of every maker takes the opposite side of every transactiontransaction

Degree of automationDegree of automation– Floor vs screen-based electronic Floor vs screen-based electronic

systemssystems

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Market architectureMarket architecture (2)(2) Protocols Protocols

– Choice of minimum tickChoice of minimum tick– Rules to halt trading, circuit breakersRules to halt trading, circuit breakers

Transparency: providing info before (quotes, Transparency: providing info before (quotes, depths) and after (actual prices, volumes) depths) and after (actual prices, volumes) trades trades – Extent of dissemination: brokers, customers, or Extent of dissemination: brokers, customers, or

publicpublic– Speed of dissemination: real time / delayed feedSpeed of dissemination: real time / delayed feed– Degree of anonymity: hidden orders, Degree of anonymity: hidden orders,

counterparty disclosurecounterparty disclosure– Permitting Permitting off-exchange / upstairs tradingoff-exchange / upstairs trading

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Basic trading systemsBasic trading systems

Batch auction / call market: NYSE openBatch auction / call market: NYSE open– Agents submit demands to the auctioneer who Agents submit demands to the auctioneer who

sets common market clearing pricesets common market clearing price Continuous auction: NYSE intraday, Continuous auction: NYSE intraday,

EuronextEuronext– Floor: brokers trade with each other on behalf Floor: brokers trade with each other on behalf

of their clientsof their clients– Electronic: the system displays the best limit Electronic: the system displays the best limit

orders and automatically executes incoming orders and automatically executes incoming market ordersmarket orders

Dealership market: NASDAQDealership market: NASDAQ– Market-makers provide bid and ask prices at Market-makers provide bid and ask prices at

which other agents may tradewhich other agents may trade

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Stock exchange vs OTCStock exchange vs OTC

Stock exchange OTC

Auction Dealer market

One center Different locations

Access only for members Much wider membership

Listing with strong requirements for companies

No or weaker requirements

Quoting: a single priceBid/ask quotes or limit order book

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NYSE vs NASDAQNYSE vs NASDAQ

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Recent developmentsRecent developments

Trading onlineTrading online Exchange-traded funds (ETFs)Exchange-traded funds (ETFs)

– Mimick indicesMimick indices– E.g., Cubes, Spiders, DiamondsE.g., Cubes, Spiders, Diamonds

Electronic Communication Networks Electronic Communication Networks (ECNs)(ECNs)– Automated systems for disclosing / Automated systems for disclosing /

executing tradesexecuting trades Program tradingProgram trading

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Structural shiftsStructural shifts

Technological innovations Technological innovations Substantial increase in Substantial increase in

trading volumetrading volume Competition between Competition between

exchanges and ECNsexchanges and ECNs Proliferation of new financial Proliferation of new financial

instrumentsinstruments

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Regulation of stock Regulation of stock tradingtrading Circuit breakersCircuit breakers

– Restrictions on trading if prices reach a Restrictions on trading if prices reach a thresholdthreshold

Legislation Legislation – Firms: public disclosure of relevant infoFirms: public disclosure of relevant info– Employees: no insider tradingEmployees: no insider trading– Market participants: fair tradingMarket participants: fair trading

Monitoring by SECMonitoring by SEC– Key divisions: CorpFin, MktRegulation, Key divisions: CorpFin, MktRegulation,

EnforcementEnforcement

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Market microstructure Market microstructure modelsmodels Price formation / discoveryPrice formation / discovery

– How prices impound info over How prices impound info over timetime

– Determinants of trading costsDeterminants of trading costs Market structure and designMarket structure and design

– Trading process vs price Trading process vs price formationformation

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Market microstructure Market microstructure modelsmodels (2)(2) TransparencyTransparency

– Info and disclosureInfo and disclosure Interaction with other areas in Interaction with other areas in

financefinance– CorpFin: IPO underpricing, stock splitsCorpFin: IPO underpricing, stock splits– Asset Pricing: liquidity as risk factor, Asset Pricing: liquidity as risk factor,

anomalies vs trading costsanomalies vs trading costs– IntlFin: ADRs, cross-border flowsIntlFin: ADRs, cross-border flows

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Selected issuesSelected issues

What are the components of the What are the components of the bid-ask spread?bid-ask spread?– Risk aversion Risk aversion – Inventory control Inventory control – Info asymmetryInfo asymmetry

Why is trading concentrated at Why is trading concentrated at the opening and closing?the opening and closing?– Optimal choice of timing the Optimal choice of timing the

transaction by uninformedtransaction by uninformed

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Selected issuesSelected issues (2)(2)

Is continuous bilateral system better Is continuous bilateral system better than periodic multilateral one?than periodic multilateral one?

Is it good for a stock to be traded in Is it good for a stock to be traded in several markets?several markets?– Gravitation vs stratificationGravitation vs stratification

Should the limit order book be Should the limit order book be displayed in public?displayed in public?

How to execute block trades How to execute block trades optimally?optimally?

ConclusionsConclusions

You make more selling You make more selling information than following itinformation than following it