The Organization of Financial Markets

1
The Organization of Financial Markets

• Bruno Biais
• Toulouse School of Economics
• Rotman Schools Distinguished lecture Series
• Toronto University
• January 2008

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Goal

• Describe the way orders are matched prices are
  formed in major financial markets.
• Understand mechanics of market process.
• Be aware of the variety of trading systems across
  countries markets.
• Knowledge necessary for theoretical analysis
  (extensive form of the game) and empirical
  studies (where does data come from?)

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Outline

• 1) Order driven markets Limit Orders, Market
  orders, Call Auction, Continuous Market.
• 2) Dealer markets
• 3) Mixed market structures

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Order driven quote driven markets
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1) Order driven markets
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Limit orders and market orders

• Limit buy order I want to buy 100 shares at
  price no larger than 60 per share.
• Market buy order I want to buy 100 shares at any
  price.
• Limit sell order I want to sell 100 shares at
  80 per share or above.
• Market buy order I want to buy 100 shares, at
  any price.

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The limit order book

• The limit orders which have been placed, and have
  not yet been executed, cancelled or revised are
  collected in the limit order book.

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A day at the exchange
Continuous market
Preopening
After hours
Close (500 CET)
Opening (900 CET)
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Call auction

• Used to set the price at the opening of the
  market (NYSE, London Stock Exchange, Paris
  Bourse, Frankfurt, Madrid, Milan,Eurex)
• All buy orders cumulated demand function
• All sell orders cumulated supply function
• Price set to maximize trading volume.
• All buy orders at or above this price filled
• All sell orders at or below this price filled

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Cumulated supply
Limit orders to sell
How much can be traded at that price
MinSupply,Demand
Cumulated demand
Limit orders to buy
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Volume maximizing price 260
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Rationing

• Because we are working with step
  functions/discrete pricing grid, at the volume
  maximizing price supply is not always equal to
  demand.
• If that happens rationing on the sell or the buy
  side. (In our example 5 sales offered at 260
  remained unexecuted).
• Time priority usually applies (First In First
  Out).

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Uniform price

• In this auction all trades are conducted at the
  same (uniform) price.
• Limit buy orders at price 355 are filled at the
  equilibrium price 260
• Limit sell orders at price 150 filled at 260
• If many traders, each has little impact on price
  price at which limit order is placed mainly
  influences its execution probability (not the
  price at which it is filled).

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Preopening tâtonnement

• Not easy to find the opening price (news,
  overnight order flow, how to react to Tokyo s
  close, etc)
• To help traders figure out this, exchanges
  (Xetra, Toronto, Euronext, Madrid, ) allow for
  order placement an hour before opening.
• Indicative preopening prices computed as traders
  place, revise, cancel orders (no trade at these
  prices).

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Does preopening period help?

• Could help coordinate expectations, advertise
  liquidity demand.
• But since orders can be withdrawn, they could be
  purely manipulative. Then preopening indicative
  prices would be pure noise.
• Biais, Hillion, Spatt (Journal of Political
  Economy, 1999) empirical study of preopening
  period in Paris Bourse. Preopening indicative
  prices do convey useful information, especially
  in the last 10 minutes..

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After the opening

• Executed buy and sell orders are no longer in the
  book. Unexecuted buy orders (placed at price
  below the opening price) and sell orders (placed
  above the clearing price) remain in the book.
• Best offer to sell ask price, best bid to buy
  bid price. Difference bid-ask spread. Quantity
  offered at the ask depth at the ask, quantity at
  the bid depth at bid.

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All the limit sell orders placed above 260 are
filled
All limit buy orders placed at or above 260 are
filled
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Depth at Best ask 5 shares
Depth at best bid 5 shares
Best bid 250
Best ask 260
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Visibility of order book

• In Xetra, Euronext, or Inet several orders on
  each side of the book are visible on traders 
  screens. Orders further away from the quotes are
  not visible. If you want to see live order book
  go to http//data.inetats.com/ds/tools/charts
  great stuff
• Until 2002, on the NYSE only the specialist saw
  the orders in the book. Since 2002 NYSE open
  book. Traders off the floor can electronically
  observe the order book.

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Inet Order Book, Dell, April 19 2006
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The continuous market

• Investors can place new market or limit orders in
  the book or cancel limit orders that have not
  been filled or trade against limit orders present
  in the book.
• If more than one order are present at a given
  price time priority applies.
• Opening multilateral trading, many investors
  participate in opening trade.
• Continuous market bilateral, match one buyer and
  one seller.

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Example

• 900 5 shares are offered at the best ask (260),
  5 more at 270.and 5 shares are demanded at the
  best bid (250).
• 905 market order to buy 2 shares immediately
  filled at price 260. Bid-ask spread remains the
  same but depth at the ask reduced.
• 906 limit order to buy 10 shares at 255, spread
  reduced to (260-255).
• 910 Market order to buy 5 shares.

p
T
Ask
260
255
Bid
250
t
900
905
906
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Order flow dynamics

• Biais, Hillion Spatt, Journal of Finance, 1994.
  
• After large purchases ask bid quotes shifted
  upward.
• When spread large, limit orders within quotes
  frequent.
• When depth at quotes limited, limit orders at
  quotes frequent.
• When spreads tight depth large, market orders
  frequent.
• Order types positively serially autocorrelated
• Large orders follow large orders.
• Buy orders follow buy orders.
• Market orders follow market orders.

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Order dynamics in Toronto Stock Exchange

• Griffiths , Smith, Turnbull White, Journal of
  Financial Economics, 2000.
• Aggressive buy (sell) orders tend to follow other
  aggressive buy (sell) orders
• They occur when bidask spreads are narrow and
  depth on the same (opposite) side of the limit
  book is large (small).
• Aggressive buys are more likely than sells to be
  motivated by information.

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Technology

• Until 80s, most stock and futures markets based
  on floors, while Nasdaq, the London Stock
  Exchange, and bond, OTC currency markets
  telephone based.
• Since 80s, trend towards electronic computer
  based trading platforms Euronext, Eurex, Xetra,
  LSE, Nasdaq, Toronto.
• Lower processing costs, greater ability to
  disseminate info connect to the market, level
  playing field/less adverse selection.
• But NYSE US futures markets still to some
  extent floor based (unlike Europ stocks
  futures).

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Best execution and price priority

• Price priority If someone offered to sell at 260
  (for example by placing an order in the book)
  then broker receiving an order to buy cannot
  execute it at a higher price Broker must seek
  best execution.
• Priority rules easier to enforce if transparent
  markets information widely disseminated even
  easier if centralized computerized order book.
• Why price priority? To prevent brokers from
  ripping off customers, to incentivize investors
  to place bids in line with their valuation of the
  asset.

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Liquidity demand and supply

• Traders placing market orders demand immediacy,
  they want rapid execution they demand liquidity
• Traders placing limit orders stand ready to trade
  with incoming market orders they supply
  liquidity.
• Intermediaries acting as market makers by placing
  limit orders earn spreads.
• Investors willing to delay execution to lower
  cost of trading avoid paying spreads.

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2) Dealer markets
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Quote driven markets

• Dealer markets are quote driven only certain
  players (have the right to) post bid and ask
  quotes and thus supply liquidity Forex market,
  OTC, US futures markets, These players are
  called market makers or dealers
• Obligations to post quotes, limit on spread,
  minimum on quantity, reporting requirements.
• Privileges right to post quotes, information
  about order flow and book, lower or no fees paid
  to the exchange.

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Dealers revenues and costs

• Revenues Dealers try to buy low (bid) sell
  high price (ask). Earn bid-ask spread.
• Costs
• Between purchase sale, hold security in
  inventory Risk bearing cost/inventory cost.
• If, market buy followed by price increase, loss
  for dealer. Arises if market orders placed by
  informed agents. Adverse selection cost.
• Competitive dealers Bid-ask spread
  compensation for inventory costs adverse
  selection costs.
• Market power spreads also reflect rents

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Why could dealership make sense ?

• 1) Fixed cost to provide liquidity link with
  electronic system, stay on floor acquire
  information.
• Efficient to spread this cost over many trades.
  Thats what professional market participants
  (dealers market makers) do. Thus, the final
  investors participating infrequently to the
  market do not incur this fixed cost.
• 2) It takes initial liquidity to attract orders
  (priming the pump) dealers can help
  coordinating expectations about liquidity.

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Potential drawbacks

• If only small group of market participants
  allowed to supply liquidity, risk of collusion.
  Tents at expense of outsiders.
• Nasdaq before 1997. Christie and Schultz (Journal
  of Finance, 1994) Nasdaq dealers traded only
  even eighths. After CSs article Wall Street
  Journal sudddenly use odd eighths.
• SEC Order Handling rule (1997) Limit orders must
  be displayed internet technology ECN run
  electronic limit order book. Investors compete to
  supply liquidity Spreads narrow.

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An important dealer market the Forex market
Today/yesterday (EBS)
Observe quotes
Bank
Customer
Customer
Bank
Bank
Post quotes
Tomorrow? (FXAll. Online FX only about 1 of
total)
Observe quotes
Bank
Customer
Customer
Bank
Bank
Post quotes
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Interdealer trading

• When one customer trades only with one dealer,
  the latter rebalances its trades with other
  dealers.
• When customers can spread their trades between
  several dealers, less need to rebalance trades.
• Empirical prediction as forex market switches to
  internet trading systems, trades between
  customers and dealers will grow relative to
  interdealer trading.

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Comparing order driven quote driven
Forex tomorrow or LSE yesterday
Observe quotes
Dealer
Customer
Customer
Dealer
Dealer
Post quotes
LSE today
Observe quotes
Dealer
Dealer
Customer
Customer
Post quotes
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3) Mixed market structures
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Mixed market structure

• Investors placing limit orders along with
  professional market makers stand ready to serve
  orders to buy or sell provide immediacy.
• NYSE as in order driven markets investors can
  enter limit orders in the book in addition
  specialists manages the book, can enter his/her
  own orders. Must maintain an orderly market.

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NYSE
Electronic Limit Order Book
Electronic order submission
Electronic order submission
Manual order
Investor
Investor
Specialist
Broker
Broker
Face to face interaction
Investor
Investor
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Who Trades on the NYSE? (Source Moulton, 2006)
Most orders and trades are electronic. For small
stocks specialist intervenes more, brokers less.
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Who Trades with Whom on the NYSE? (Source
Moulton, 2006)
Most trades involve electronic orders on one or
both sides. Percentage pretty stable across
stocks.
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Advantages of this dual system

• Investors can place limit orders, and thus
  compete to supply liquidity, especially since
  2002, NYSE open book.
• Specialist constantly monitors market, intervenes
  to supply liquidity if transient mismatch
  (intertemporal intermediation.)
• Long term relationship between brokers and
  specialists reputation effects can mitigate
  adverse selection problems.

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Drawbacks

• Until 2006, direct access to electronic system
  (NYSE Direct ) limited Order size lt 1099
  shares. Not more than one order per 30 seconds.
• NYSE rules allow brokers on the floor to violate
  time priority of orders in the book, stepping in
  before order is hit.
• Competition between floor and electronic book
  biased adverse selection problem for floor.

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Hybrid market

• Approved by SEC March 2006. Lift restriction on
  Direct orders 1099 shares and 30 secs.
• Investors who want direct and immediate execution
  against the order book can request it NX. NX
  orders can sweep the book.
• Investors who prefer to allow specialist or
  broker to step in can request it.
• These new rules make NYSE more similar to
  European electronic limit order books, while
  keeping some of the advantages drawbacks.

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Brokers in hybrid market

• Brokers can electronically place limit orders in
  the book e-quotes.
• Brokers can choose to hide these orders or make
  them visible (// Euronext or Inet.)
• Only brokers can hide orders (way to preserve
  some of the franchise of brokers.)
• Specialist can see aggregate amount of hidden
  orders but not details (way to preserve
  specialists franchise.)

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LRPs in hybrid market

• Liquidity replenishment points.
• When large price change If individual order
  moves stock price by gt 9 cents. Or if stock price
  moves by gt 25 cents or 1 price in 30 secs.
• Maybe due to transient lack of liquidity.
• Automatic execution halted. Specialist tries to
  elicit liquidity supply. Automatic market starts
  again after manual trade or 10 secs.

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LRP Tradeoffs

• Pros LRP maybe triggered by transient lack of
  liquidity lots of relatively uninformed buy
  orders, liquidity demand exceeding depth in the
  book, optimal to advertise this imbalance call
  for liquidity supply.
• Cons Automatic execution halted, specialist and
  floor brokers find out if sudden flow of market
  order was uninformed. If it was, provide
  liquidity. Otherwise execute against book.
  Adverse selection problem for book.
• Solution Run electronic auction with equal
  access to floor electronic traders?

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Conclusion

• Trend in equity markets (and also other markets
  such as government bonds or forex) Electronic
  limit order books. NYSE was able to resist this
  trend for a long time because of its quasi
  monopoly position. European Exchanges, which
  competed against one another had to move earlier.
  
• Trend much less clear in other markets,
  especially bond market. There OTC dealership
  prevails. Why? Is this going to last? What are
  the consequences?