1. Centralised Order Books versus Hybrid Order Books: Jean-François Gajewski Université de Paris XII Val de Marne, IRG Carole Gresse Université Paris Dauphine, CEREG A Paired Comparison of Trading Costs on NSC (Euronext) and SETS (London Stock Exchange)

2. Topic of the paper Differences in trading mechanisms may imply differences in execution costs and spread components Harris(1997), Domowitz et al. (2001), Jain (2001) … Many papers  order-driven markets vs. quote-driven markets Madhavan(1992), Pagano and Roëll (1992,1996), De Jong, Nijman and Roëll (1996), Huang and Stoll (1996) … But few compare different types of order books Venkataraman (2001), Kasch-Haroutounian and Theissen (2003) Two order-driven market designs SETS (London Stock Exchange) Large caps (FTSE-100…), order book + multiple dealers NSC (Euronext) almost pure centralised order-driven market Common features / Organisational differences

3. Organisational featureNSC (Euronext Paris)SETS (LSE) Trading mechanism Automated order-driven continuous market for most liquid stocks Automated order-driven continuous market for Blue Chips Trading day scheduleOpening call auction: 9.00 am Continuous auction: 9.00-17.30 Closing call auction: 17.35 pm Opening call auction: 8.00 am Continuous auction: 8.00- 16.30 Closing call auction at 16.35 Liquidity providers Patient investors (limit orders) RSPs for retail orders Broker-dealers outside the book Priority rules Price Time Price Time Trading mechanism for ordinary trades Matching of orders in the electronic order book Applications Matching of orders in the order book Bilateral negotiations with dealers off the order book Retail orders processed by RSPs, generally at a price at least as favourable as the order book best limit

4. Organisational featureNSC (Euronext Paris)SETS (LSE) Block market Procédure de bloc Working Principal Agreement VWAP trades Not practicableProcessed by broker-dealers outside the order book Tick size Price < 50 € : 0,01 € Price >50 and <100 € : 0,05 € Price >100 and <500 € : 0,1 € Price >500 € : 0,5 € Price < 5£: 0,25 p Price>5 and <10£: 0,5 p Price >10£: 1 p Organisational differences Matching of all orders in the NSC electronic order book on Euronext Bilateral negotiations with dealers outside the order book at the LSE Processing of retail orders by Retail Service Providers at the LSE

5. Testable hypotheses Superiority of mixed structures (Jain (2001), Gresse (2002), Swan and Westerholm (2004)) Fragmentation effects (Mendelson (19987), Chowdry and Nanda (1991), Easley, Kiefer & O’Hara (1996)) Volatility H1. Prices are less volatile in the HOM (SETS) than in the COM (NSC). Spreads and trade size H2. The internalisation of a substantial part of the order flow by dealers in the HOM fragments the market and enlarges quoted and effective spreads. H3. Additional depth provided by dealers out the OB in the HOM increases trade size (H3a) lower trading costs on large transactions (H3b) Spread components H4. Order-processing costs are greater in the HOM than in the COM. H5. Inventory costs are greater in the HOM than in the COM. H6. Higher pre-trade transparency in the COM  higher adverse selection costs H7. ASC inside the order book of a HOM are greater than those incurred in a COM.

6. Data and methodology Data selection Trading data and quotes during the first six months of 2001 211 securities continuously traded on Euronext Paris 157 securities listed on SETS at the LSE Sample matching The Dow Jones economic sector The free float capitalisation on January 2001 The total trading volume (€) during the first semester of 2001 55 pairs of stocks

7. Measurement of volatility, trading costs and spread components Quoted spreads Effective spreads Effective marginal costs (empirical estimation of the Kyle’s coefficient) Spread components : Huang and Stoll’s methodology Short-term volatility

8. Analysis of execution costs on SETS and NSC Trading mechanismNSC SETS In the order book Off the order book Total trading volume (thousand €)453,696,215 160,735,063 (44.42%) 201,153,419 (55.58%) Volatility ratio1.48652.3186 Quoted spread0.2585%0.7048% Average number of quotes per day1,802.22423.29 Effective spread0.2503%0.4024%0.4859% Effective marginal cost0.0703%0.2238%0.2613% Average number of trades per day145,54734,41335,055 Average trade size (€)45,94463,705135,192

9. Share in trading volume by transaction class 1.28% 5.03% 11.62% 10.15% 22.26% 16..7% 10.99% 7.27% 14.71% 0.76% 3.39% 5.37% 15.97% 16.34% 14.52% 15.69% 21.73%

10. Effective spreads by transaction class 0.2537% 0.2469%0.2476%0.254% 0.2673%0.2793%0.2564% 0.2348% 0.9591% 0.4103% 0.4038% 0.4147% 0.6069% 0.6686% 0.7046% 0.7571% 0.2129% 0.457% 0.5025% 0.5736% 0.4199% 0.4386% 0.4704%0.4622% 0.3435%

11. Components of the bid-ask spread on NSC and SETS (1) Market Parameter Adverse selection and inventory holding cost component MeanStd. Err.MedianTS SETS (all trades) SETS 17.59%0.107516.01% SETS (order book trades only) SETS_iob 44.53%0.015144.59% NSC  NSC 38.16%0.009736.55% SETS vs NSC SETS - NSC -20.57%***0.0139-20.51%***-14.76 -3.37 (52<0) SETS(ob) vs NSC SETS_iob - NSC 6.36%***0.01636.34%*3.9 1.82 (37>0) Huang & Stoll’s 2-way decomposition (GMM estimation)   = ASC + IHC in % of the spread 1 - = order processing costs in % of the spread

12. Components of the bid-ask spread on SETS and NSC (2) Market Nb of stocks  Mean SETS (all trades) 180.41345.82%11.52% SETS (order book trades only) 440.421428.6%25.57% NSC250.51489.24%17.43% Huang & Stoll’s 3-way decomposition (GMM estimation)  = adverse selection component  = inventory holding cost component Same conclusions with non-parametric tests on a 7-pair matched sample

13. Economic and institutional factors explaining the difference in spreads: Panel regressions  Float cap. is not significant  # trades,  P: ns

14. Concluding remarks Volatility Short-term volatility of SETS stocks significantly exceeds the one of NSC stocks (Rejection of H1). Spreads and trade size The hybrid order-driven market is globally more expensive (H2, rejection of H3b) but trades are larger in this market (H3a). Spread components The order processing cost component = a much bigger part of the spread on the hybrid market than on the centralised order book (H4). Weight of the inventory holding component is not lower on NSC than on SETS (rejection of H5) Higher on SETS when considering order book trades only. ASC on SETS < ASC on NSC (week evidence, H6) but ASC is maximum on SETS when considering order book trades only (H7). Factors tick size & share of volume executed by dealers in the SETS market