Biais powerpoint lecture_1

The Organization of Financial Markets

Bruno BiaisToulouse School of Economics

Rotman School’s Distinguished lecture SeriesToronto University

January 2008

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?)

Outline

• 1) Order driven markets: Limit Orders, Market orders, Call Auction, Continuous Market.

• 2) Dealer markets

• 3) Mixed market structures

Order driven & quote driven marketsOrder driven markets

Mixed/hybrid market structures

Quote driven markets

All investors can announce prices at which they want to buy or sell (via brokers)

As in order driven + specialist or market makers

Only specialist/ market makers/ dealers post quotes

Euronext, Tokyo, Inet, Hong Kong, Toronto Stock Exchange

Frankfurt, London, NYSE, Nasdaq, Matif, Xetra, Eurex (see www.eurexchange.com)

London & Nasdaq before 1997, FX, Bonds,

Derivatives

1) Order driven markets

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.

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.

A day at the exchange

Opening(9:00 CET)

Close(5:00 CET)

Continuous marketPreopening After hours

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

The limit order book at the opening of the market

PriceLimit sell ordersSupply Limit buy orders Demand Volume50 10 10 0 170 1060 10 20 0 170 2070 0 20 0 170 2080 5 25 0 170 2590 0 25 0 170 25

100 10 35 10 170 35110 10 45 0 160 45120 0 45 0 160 45130 0 45 0 160 45140 0 45 0 160 45150 5 50 10 160 50160 10 60 10 150 60170 5 65 10 140 65180 10 75 0 130 75190 0 75 5 130 75200 0 75 5 125 75210 0 75 5 120 75220 0 75 0 115 75230 10 85 0 115 85240 10 95 5 115 95250 5 100 5 110 100260 10 110 10 105 105270 5 115 10 95 95280 5 120 0 85 85290 0 120 0 85 85300 5 125 0 85 85310 5 130 5 85 85320 5 135 5 80 80330 10 145 5 75 75340 10 155 0 70 70350 5 160 0 70 70360 5 165 10 70 70370 5 170 10 60 60380 0 170 10 50 50390 0 170 10 40 40400 0 170 10 30 30410 0 170 10 20 20420 0 170 0 10 10430 0 170 0 10 10440 0 170 5 10 10450 0 170 5 5 5

Cumulated supply

Limit ordersto sell

Cumulateddemand

How much can be tradedat that price =Min[Supply,Demand]

Limit orders to buy

Supply and demand at the opening call auction

020406080

100120140160180

0 50 100 150 200 250 300 350 400 450 500

Price

Qu

an

tity

Supply

Demand

Volume maximizingprice: 260

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).

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).

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).

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..

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.

The order book just after the opening of the market

PriceLimit sell orderSupply Limit buy order Demand50 0 0 0 6560 0 0 0 6570 0 0 0 6580 0 0 0 6590 0 0 0 65100 0 0 10 65110 0 0 0 55120 0 0 0 55130 0 0 0 55140 0 0 0 55150 0 0 10 55160 0 0 10 45170 0 0 10 35180 0 0 0 25190 0 0 5 25200 0 0 5 20210 0 0 5 15220 0 0 0 10230 0 0 0 10240 0 0 5 10250 0 0 5 5260 5 5 0 0270 5 10 0 0280 5 15 0 0290 0 15 0 0300 5 20 0 0310 5 25 0 0320 5 30 0 0330 10 40 0 0340 10 50 0 0350 5 55 0 0360 5 60 0 0370 5 65 0 0380 0 65 0 0390 0 65 0 0400 0 65 0 0410 0 65 0 0420 0 65 0 0430 0 65 0 0440 0 65 0 0450 0 65 0 0

All the limitsell ordersplacedabove 260 are filled

All limitbuy ordersplaced at or above 260are filled

The order book just after the opening call

0

10

20

30

40

50

60

70

0 50 100 150 200 250 300 350 400 450 500

Price

Qu

an

tity

Supply

Demand

Best bid: 250 Best ask: 260

Depth at Best ask: 5 shares

Depth at bestbid: 5shares

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.

Inet Order Book, Dell, April 19 2006

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.

Example• 9:00: 5 shares are offered at the best ask (260), 5 more at

270.and 5 shares are demanded at the best bid (250). • 9:05: market order to buy 2 shares; immediately filled at

price 260. Bid-ask spread remains the same but depth at the ask reduced.

• 9:06: limit order to buy 10 shares at 255, spread reduced to (260-255).

• 9:10: Market order to buy 5 shares.

p

t

260

250

9:00 9:05 9:06

Ask

Bid255

T

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.

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 bid–ask 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.

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).

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.

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.

2) Dealer markets

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.

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

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. That’s 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.

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 CS’s 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.

An important dealer market: the Forex market

Customer Customer

Bank

Bank

Bank

Today/yesterday (EBS):Observe quotes

Post quotes

Customer Customer

Bank

Bank

Bank

Tomorrow? (FXAll. Online FX only about 1% of total):Observe quotes

Post quotes

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.

Comparing order driven & quote driven

CustomerCustomer

Dealer

Dealer

Dealer

Observe quotes

Post quotes

Forex tomorrow or LSE yesterday:

Customer

Customer

Dealer Dealer

Observe quotes

Post quotes

LSE today:

3) Mixed market structures

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.”

NYSE

Investor

Investor

Investor

Investor

Electronic Limit Order Book

Electronic ordersubmission

Electronic ordersubmission

Specialist

Broker Broker

Manual order

Face toface interaction

Who Trades on the NYSE?(Source Moulton, 2006)

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

80,00%

Who trades

SpecialistFloor brokerSystem

Most orders and trades are electronic.For small stocks specialist intervenes more, brokers less.

Who Trades with Whom on the NYSE?(Source Moulton, 2006)

0,00%5,00%

10,00%15,00%20,00%25,00%30,00%35,00%40,00%45,00%50,00%

Who trades with whom?

Pure floorFloor & systemPure system

Most trades involve electronic orders on one or both sides.Percentage pretty stable across stocks.

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.

Drawbacks

• Until 2006, direct access to electronic system (NYSE Direct +) limited: Order size < 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.

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.

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 specialist’s franchise.)

LRPs in hybrid market

• Liquidity replenishment points.

• When large price change: If individual order moves stock price by > 9 cents. Or if stock price moves by > 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.

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?

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?