1. Market Structure, Trading, and LiquiditySlide 1 MBA 8750 – Current Topics Seminar The Current State and Structure of U.S. Financial Markets: Implications from the 2010 “Flash Crash” Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance Professor of Finance Villanova School of Business May 12, 2011

2. Market Structure, Trading, and LiquiditySlide 2 Overview of Seminar Agenda ItemPresenterTime Welcome & Introduction to the SeminarMike Pagano6:00-6:05 The “Flash Crash” and what it means for you and your firm Mike Pagano6:05-6:30 Open Outcry Trading ExerciseAll6:30-6:50 The Role of Options in Investing and MarketsLou DePaul6:50-8:00 How Trading Firms can add value for InvestorsMike Pagano and All8:00-8:45 Wrap-up and Post-WorkMike Pagano8:45-9:00

3. Market Structure, Trading, and Liquidity 3 Is trading this simple? …

4. Market Structure, Trading, and Liquidity 4 or slightly more difficult ??

5. Market Structure, Trading, and Liquidity 5 What Motivates Trading? 1.New information (unexpected news) 2.Liquidity needs 3.Divergent expectations (people agree to disagree) 4.Technical (noise) trading

6. Market Structure, Trading, and LiquiditySlide 6 Fundamental Financing Channels FirmInvestor FirmInvestor IB / CB BuyerSeller Agent Exchange or Market Maker Agent

7. Market Structure, Trading, and LiquiditySlide 7 The Equity Markets U.S. Equity Market Centers s National Markets: NYSE, Nasdaq, BATS, DirectEdge s Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia s Over-the-Counter Market (OTC) s Alternative Markets (ATSs, ECNs, “Dark Pools”), e.g.: –INET (ECN part of Nasdaq now) –Arca (part of NYSE Euronext now) –POSIT (Investment Technology Group) –Liquidnet and Pipeline (private block trading networks) –Sell-side Dark Pools run by Goldman, Credit Suisse, etc.

8. Market Structure, Trading, and LiquiditySlide 8 Trading Players Retail Investors Institutional Investors High Frequency Traders (HFTs) Speculators Dealers / Market Makers Brokers Exchanges Off-Exchange Trading Systems Corporate Issuers Regulators

9. Market Structure, Trading, and LiquiditySlide 9 Major Trading Issues Liquidity Informative Prices Volatility Transaction Costs Trading Profits Net Investment Returns

10. Market Structure, Trading, and LiquiditySlide 10 The Iceberg of Transaction Costs Source: Plexus Group, 2003 Commission 5 ¢ (17 bp)Impact 10 ¢ (34 bp) Delay 23 ¢ (77 bp) Missed Trades 9 ¢ (29 bp)

11. Market Structure, Trading, and LiquiditySlide 11 Trading Cost Components Total Cost = Commission + Impact (intra-day) + Delay (inter-day) approx. 157 bps (one-way)  314 bps (round-trip!) What is the cumulative impact on a 10% gross annual return over just 1 year? Answer: Net return is only 6.57% (a 34.2% decrease!)

12. Market Structure, Trading, and LiquiditySlide 12 10:50 10:55 11:00 Public Buyer Public Seller Limit Order Executes Places a Buy Limit Order Order Driven Market The limit order book brings buyer& seller together

13. Market Structure, Trading, and LiquiditySlide 13 The Limit Order Book Bid – Ask Spread (10.95 - 11.10) Air Pocket

14. Market Structure, Trading, and LiquiditySlide 14 Ask Bid P* Day 1 Day 2 P* and Best Bid and Offer Quotes

15. Market Structure, Trading, and LiquiditySlide 15 Order Flow is “Fuel” For a Market Order Flow = Liquidity An excellent system will not operate if it does not receive Critical Mass Order Flow “Order flow attracts order flow”

16. Market Structure, Trading, and LiquiditySlide 16 Liquidity Main Attributes of a liquid asset  Breadth: orders on the book exist at an array of prices in the close neighborhood above and below the price at which shares are currently trading.  Depth: orders are of large size.  Resiliency: price changes due to temporary order imbalances quickly attract new orders to the market, thereby restoring reasonable share values.  Frequent trading (at high speed).

17. Market Structure, Trading, and LiquiditySlide 17 The Raison d’être of Algorithmic Trading o Dynamic price discovery o The fast speed in which events can occur o Exploit Market inefficiencies to ↓ costs and ↑ profits

18. Market Structure, Trading, and LiquiditySlide 18 The 9/30/2010 CFTC - SEC “Flash Crash” Report

19. Market Structure, Trading, and LiquiditySlide 19 Flash Crash Summary of Events The events of May 6 can be separated into 5 phases (shown in Figures 1.1 and 1.2 on following slides): Phase 1: From the market’s open through about 2:32 p.m., prices were broadly declining across markets, with stock market index products sustaining losses of about 3%. Phase 2: From about 2:32 p.m. through about 2:41 p.m., the broad markets began to lose more ground, declining another 1-2%. Phase 3: Between 2:41 p.m. and 2:45:28 p.m., lasting only about four minutes or so, volume spiked upwards and the broad markets plummeted a further 5-6% to reach intra-day lows of 9-10%. Phase 4: From 2:45 p.m. to about 3:00 p.m., broad market indices recovered while at the same time many individual securities and ETFs experienced extreme price fluctuations and traded in a disorderly fashion at prices as low as one penny or as high as $100,000. Phase 5: At about 3:00 p.m., prices of most individual securities significantly recovered and trading resumed in a more orderly fashion.

20. Market Structure, Trading, and LiquiditySlide 20 More on the Flash Crash… 1.STOCK INDEX PRODUCTS: THE E-MINI FUTURES CONTRACT AND “SPY” EXCHANGE TRADED FUND (ETF) 2.A LOSS OF LIQUIDITY IN THE E-MINI AND “SPY” ETF MARKETS 3.AUTOMATED EXECUTION OF A LARGE SELL ORDER IN THE E- MINI FUTURES CONTRACT 4.CROSS-MARKET PROPAGATION (FUTURES TO CASH MARKETS) 5.LIQUIDITY IN THE INDIVIDUAL STOCKS THAT COMPRISE THE S&P 500 INDEX

21. Market Structure, Trading, and LiquiditySlide 21 Key Graphs from CFTC / SEC Flash Crash Report

22. Market Structure, Trading, and LiquiditySlide 22 Key Graphs from Joint Flash Crash Report (cont.)

23. Market Structure, Trading, and LiquiditySlide 23 Key Graphs from Joint Flash Crash Report (cont.)

24. Market Structure, Trading, and LiquiditySlide 24 Key Graphs from Joint Flash Crash Report (cont.)

25. Market Structure, Trading, and LiquiditySlide 25 Key Graphs from Joint Flash Crash Report (cont.)

26. Market Structure, Trading, and LiquiditySlide 26 Key Graphs from Joint Flash Crash Report (cont.)

27. Market Structure, Trading, and LiquiditySlide 27 Key Graphs from Joint Flash Crash Report (cont.)

28. Market Structure, Trading, and LiquiditySlide 28 Key Regulatory Topics  HFT and Market Stability (limit up/dn; breakers)  Reg NMS and Market Fragmentation  Level Playing Field: NYSE, Nasdaq, ECNs, ATS  Fairness for Retail vs. Institutional Investors  Insider Trading and Increased Surveillance  Mergers of For-Profit Exchanges / ATS firms  Impact on Corporate Issuers (e.g., WACC, prices)

29. Market Structure, Trading, and LiquiditySlide 29 Homework Assignment Written deliverable (reflection paper on pre-work and in-class activities) to be graded by Prof. Pagano. The assignment will be to discuss the concepts and experiences from this class that were most salient to your own personal investments and / or your firm’s situation. Please limit your response to 350 to 500 words (i.e., 1-2 pages, double-spaced with 12 point font size).