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The Equity Markets Microstructure Seminar Baruch College 11-12 November 2004 Market Microstructure: Seven Key Lessons Wayne H. Wagner, Chairman Plexus.

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Presentation on theme: "The Equity Markets Microstructure Seminar Baruch College 11-12 November 2004 Market Microstructure: Seven Key Lessons Wayne H. Wagner, Chairman Plexus."— Presentation transcript:

1 The Equity Markets Microstructure Seminar Baruch College November 2004 Market Microstructure: Seven Key Lessons Wayne H. Wagner, Chairman Plexus Group, Inc. a subsidiary of JPMorgan Chase Bank

2 Seven Key Lessons 1.Good markets are essential to a robust economy. 2.Uninformed traders lose to informed traders. 3.Good market design is critical. 4.Technology is changing markets radically. 5.The important costs of trading are hidden. 6.It’s not a zero sum game. 7.Markets can fail.

3 1. Good Markets Are Essential to a Robust Economy Efficient pricing of assets and expectations. Aggregation and interaction of information Expression of choices Prices allocate resources for the future Pricing of risk and risk transfer Fear and greed: moral hazard Transference of risk (e.g. options) Arbitrage of risk (rule of one price) Liquidity: Easily exchangeable assets are worth more. Facilitation of liquidity Prices reflect all the above

4 Echoes of Friedrich Hayek Information costs are reduced by the existence of large numbers of buyers and sellers. Under these conditions, prices embody the same information that would require large search costs by individual buyers and sellers in the absence of an organized market. Douglas North The market is smarter than any participant in it! Jack Treynor

5 2. Uninformed Traders Lose to Informed Traders Dem dat know, know dat they know; Dem dat don’t know, don’t know dey don’t know. Maria Muldaur, lightly talented barroom singer who attained one fleeting moment of fame for “Midnight at the Oasis” “And dat’s the name of the game.” Mike Epstein, highly talented NASDAQ market maker MIT professor, possibly interesting barroom singer, who is here and now attaining one fleeting moment of fame. Thank Heaven for the Uninformed Traders!

6 Meet an Informed Trader Hi! I’m an informed trader and I’m here to help the market efficiently price assets!

7 Meet an Informed Trader Meet an Uninformed Trader

8 2. Uninformed Traders Lose to Informed Traders? Informed traders hide as uninformed traders. Many uninformed traders think they're informed. A manager who’s right 55% of the time is an investment genius. He doesn’t know which ideas he’s “informed” about. YET there are informed traders, informed mostly about pending supply & demand imbalance. Therefore dealers have to act without knowing whether the trader is informed or not. Some sheep are wolves. Some wolves are sheep. Some don’t know when they’re wolves or sheep. There really are wolves! All sheep are wolves until proven otherwise.

9 Who Am I Trading With?

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12 Wagner’s Simple Minded Explanation of Dealer Behavior when Informed Traders Disguise Themselves Long too many shares: Short too many shares: I can’t distinguish between informed and uninformed. The fundamental problem is risk control. Encourage buyers & discourage more sellers with low quotes. Encourage sellers & discourage more buyers with high quotes. I’ll trade with anybody, if it reduces my inventory risk to within my tolerance bands.

13 3. Good Market Design is Critical! Bad design can create large, unexpected deviations from expectations: Optimark: failed to deliver value to users. California Energy Market: successful at delivering value to abusers. Good design can create large, unexpected deviations from expectations: Decimalization and Order Handling Rules.

14 Decimalization and Order Handling Rules Two major changes Many more price points Ability for “naturals” to compete with dealers via limit orders Unintended effects (or were they really that clever?): Enhanced control of the order by the buyside Disintermediation of the broker: what’s the value proposition now? Less leakage of trading information Lower trading costs!

15 Costs Are Already Coming Down! 4 th qtr 2000 vs 4 th qtr 2003 Source: Plexus Group, 2004

16 The agency conflicts inherent in a “relationship” market are reduced. Transaction cost hurdles to superior performance are smaller. Profitable new strategies, e.g. stat/arb, are now possible. Technology is enabling completely integrated end-to-end investment processes: Integrated Decision Models Order Management Systems Algorithmic Trading Engines FIX Connectivity Competition among markets Straight Through Processing Disintermediation is redefining the role of the dealer. Investors Are Taking Control of the Trading Process

17 4. Technology Is Radically Changing Markets “Darwinian adaptation,” triggered by technological and regulatory aegis, is completely changing the markets. Institutional trading practices today are radically different than they were just 3-4 years ago. Unattractive market structures are losers. They die. Investors are winners.

18 An Manual Investment Management Process ( Circa ) Which securities to buy? How much to buy? How to trade? Phone sls trader Decision Process Write up order Send to booth Walk to floor Execute Inform sls trader Inform customer Inform back office Clearing Settlement Handoff to brokering Handoff to accounting Execution Process Settlement Process Time frame measured in days

19 What’s Wrong with This Picture?? Stuck in a Graham and Dodd world. Absolutely casual about elapsed time. Sequential solutions, instead of jointly determined. Ignorant of co-dependencies. E.g.: trade cost affects outcomes of security picks. Prone to error at every step. Too many steps involved; prone to sub-optimization. Too many agents involved; prone to information leakage to “prying eyes.” Excessively costly!

20 A Fully Integrated Decision, Execution and Settlement Process Which securities to buy? How much to buy? How to trade? Integrated Decision Process Check for liquidity Route to market Execute Update OMS, Accounting Automated clearing, settlement Auto-notification of interested parties Integrated Execution Process Integrated Accounting Process Circa 2010?

21 5. The Important Costs of Trading Are Hidden Source: Plexus Group, 2003 Commission 5 ¢ (17 bp)Impact 10 ¢ (34 bp) Delay 23 ¢ (77 bp) Missed Trades 9 ¢ (29 bp)

22 Best Execution Is Much More than an Exercise in Compliance or Monitoring Agents The CFA-Institute Trade Management Guidelines¹ define Best Execution as: The Trading Process Most Likely to Maximize the Value of Client Portfolios. This is a manager’s duty, akin to prudency. Delay and opportunity costs are exclusively the responsibility of the buyside.

23 6. Not a Zero Sum Game! A Nash equilibrium, not “winner takes all” situation. All players consider other players interests as they design their strategies. All solve for best personal outcome given the competition. Open to new players who join only if they see a positive personal outcome. Market design should: Favor those who perform research, Charge those who demand liquidity, and Encourage those willing to provide liquidity for trading profits.

24 7. Markets Can Fail! The Unforgettable Lesson of the 1987 Crash Markets work only when willing buyers meet willing sellers. When either group is scarce to the point of absence, markets cannot find clearing prices. 1987: all sellers, no buyers. Markets balance fear and greed. Moral Hazard: Fear is an absolute necessity for functional markets. Portfolio insurance created “riskless” investments. When markets fail, the rules of economics are co-opted by psychologically driven behavior. Fear comes back with overwhelming power. Market failure created the risk needed to rebalance the greed.

25 7. Markets Can Fail! The spirit of speculation is anarchic, irreverent, and anti-hierarchic. It loves freedom, detests cant, and abhors restrictions.... [S]peculation has established itself as the most demonic of economic activities. Although profoundly secular, speculation is not simply about greed. The essence of speculation remains a Utopian yearning for freedom and equality which counterbalances the drab rationalistic materialism of the modern economic system. Throughout its many manifestations, the speculative mania has always been, and remains to this day, the Carnival of Capitalism, a “Feast of Fools.” Edward Chancellor Devil Take the Hindmost 1999 Thank Heaven(?) for the Uninformed Traders!

26 The Equity Markets Microstructure Seminar Baruch College November 2004 Market Microstructure: Seven Key Lessons Wayne H. Wagner, Chairman Plexus Group, Inc. a subsidiary of JPMorgan Chase Bank


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