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

NES FF 2005/06 2 Plan Why is the organization of trading process important for investors? Buying and selling Buying and selling –Short sales –Margin and leverage effect Classification of financial markets Classification of financial markets –Primary vs secondary markets –Exchange vs OTC markets

NES FF 2005/06 3 Examples Ticks Ticks –1/8 vs 1/32 vs decimal Price over 100 Price over 100 –Stock splits Analyst recommendations Analyst recommendations –Conflict of interests Failure of LTCM Failure of LTCM

NES FF 2005/06 4 Market participants Brokers Brokers –Trading on behalf of a client Dealers Dealers –Trading for their own account Market-makers Market-makers –Providing bid-ask quotes

NES FF 2005/06 5 Placing an order Market Market Limit Limit Short sale Short sale –‘Selling a cow, which you don’t own’ –Borrow a stock from (another client of) your broker Stop loss/buy Stop loss/buy –Conditional market order: to lock in gains

NES FF 2005/06 6 Margin trading Initial / maintenance margin Initial / maintenance margin –% of MV(assets) kept in the account as collateral –The rest is borrowed from the broker Margin call Margin call –If the amount in the account drops below maintenance margin Leverage effect: Leverage effect: r = (ΔP - interest) / (P 0 margin)

NES FF 2005/06 7 Classification of financial markets Bank credits Bank credits –Commercial vs Interbank Foreign exchange (FX) Foreign exchange (FX) –Spot / forward exchange –Deposit-loan National markets National markets Euro markets Euro markets

NES FF 2005/06 8 Classification of financial markets (2) Security market Security market –Primary –Secondary Exchange: Exchange: –NYSE, LSE (stocks) –CBOT, LIFFE (derivatives) OTC (over-the-counter) OTC (over-the-counter) –NASDAQ

NES FF 2005/06 9 Desirable characteristics Informational transparency Informational transparency Min transaction costs Min transaction costs Liquidity Liquidity –Ability to open or close large positions without strong effect on prices –Tightness / depth / resiliency Informational efficiency Informational efficiency –Speed of incorporating information to prices

NES FF 2005/06 10 Market architecture Degree of continuity Degree of continuity –Periodic vs continuous systems Reliance on market makers Reliance on market makers –Auction / order-driven market –Dealer / quote-driven market: market maker takes the opposite side of every transaction Degree of automation Degree of automation –Floor vs screen-based electronic systems

NES FF 2005/06 11 Market architecture (2) Protocols Protocols –Choice of minimum tick –Rules to halt trading, circuit breakers Transparency: providing info before (quotes, depths) and after (actual prices, volumes) trades Transparency: providing info before (quotes, depths) and after (actual prices, volumes) trades –Extent of dissemination: brokers, customers, or public –Speed of dissemination: real time / delayed feed –Degree of anonymity: hidden orders, counterparty disclosure –Permitting off-exchange / upstairs trading

NES FF 2005/06 12 Basic trading systems Batch auction / call market: NYSE open Batch auction / call market: NYSE open –Agents submit demands to the auctioneer who sets common market clearing price Continuous auction: NYSE intraday, Euronext Continuous auction: NYSE intraday, Euronext –Floor: brokers trade with each other on behalf of their clients –Electronic: the system displays the best limit orders and automatically executes incoming market orders Dealership market: NASDAQ Dealership market: NASDAQ –Market-makers provide bid and ask prices at which other agents may trade

NES FF 2005/06 13 Stock exchange vs OTC Stock exchangeOTC AuctionDealer market One centerDifferent locations Access only for membersMuch wider membership Listing with strong requirements for companies No or weaker requirements Quoting: a single price Bid/ask quotes or limit order book

NES FF 2005/06 14 NYSE vs NASDAQ

NES FF 2005/06 15 Recent developments Trading online Trading online Exchange-traded funds (ETFs) Exchange-traded funds (ETFs) –Mimick indices –E.g., Cubes, Spiders, Diamonds Electronic Communication Networks (ECNs) Electronic Communication Networks (ECNs) –Automated systems for disclosing / executing trades Program trading Program trading

NES FF 2005/06 16 Structural shifts Technological innovations Technological innovations Substantial increase in trading volume Substantial increase in trading volume Competition between exchanges and ECNs Competition between exchanges and ECNs Proliferation of new financial instruments Proliferation of new financial instruments

NES FF 2005/06 17 Regulation of stock trading Circuit breakers Circuit breakers –Restrictions on trading if prices reach a threshold Legislation Legislation –Firms: public disclosure of relevant info –Employees: no insider trading –Market participants: fair trading Monitoring by SEC Monitoring by SEC –Key divisions: CorpFin, MktRegulation, Enforcement

NES FF 2005/06 18 Market microstructure models Price formation / discovery Price formation / discovery –How prices impound info over time –Determinants of trading costs Market structure and design Market structure and design –Trading process vs price formation

NES FF 2005/06 19 Market microstructure models (2) Transparency Transparency –Info and disclosure Interaction with other areas in finance Interaction with other areas in finance –CorpFin: IPO underpricing, stock splits –Asset Pricing: liquidity as risk factor, anomalies vs trading costs –IntlFin: ADRs, cross-border flows

NES FF 2005/06 20 Selected issues What are the components of the bid-ask spread? What are the components of the bid-ask spread? –Risk aversion –Inventory control –Info asymmetry Why is trading concentrated at the opening and closing? Why is trading concentrated at the opening and closing? –Optimal choice of timing the transaction by uninformed

NES FF 2005/06 21 Selected issues (2) Is continuous bilateral system better than periodic multilateral one? Is continuous bilateral system better than periodic multilateral one? Is it good for a stock to be traded in several markets? Is it good for a stock to be traded in several markets? –Gravitation vs stratification Should the limit order book be displayed in public? Should the limit order book be displayed in public? How to execute block trades optimally? How to execute block trades optimally?

Conclusions You make more selling information than following it