Market microstructure lecture 02 daniel sungyeon kim
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Market Microstructure Lecture 02 Daniel Sungyeon Kim. Investments vs. This class. Selection. Fund A manager. Fund A manager. Fund A manager. Request. Request. Request. Implementation. Order desk. Order. Order. Exchange 1. Exchange 2. Exchange 3.

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Market Microstructure Lecture 02 Daniel Sungyeon Kim

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Market MicrostructureLecture 02Daniel Sungyeon Kim


Investments vs. This class

Selection

Fund A manager

Fund A manager

Fund A manager

Request

Request

Request

Implementation

Order desk

Order

Order

Exchange 1

Exchange 2

Exchange 3

  • Investments covers selection and ignores implementation

  • This class covers implementation and ignores selection

Analogy to how large institutional traders divide up the overall trading task:


What is market microstructure?

  • Market microstructure studies the process by which investors' latent demands are ultimately translated into prices and volumes.

  • - Madhavan (2000)

The Market Microstructure Working Group is devoted to theoretical, empirical, and experimental research on the economics of securities markets, including: the role of information in the price discovery process; the definition, measurement, control, and determinants of liquidity and transactions costs; and their implications for the efficiency, welfare, and regulation of alternative trading mechanisms and market structures.

- NBER Market Mircostructure working group


Harris, Chapter 2 Trading StoriesA Retail Trade in a NYSE-listed Stock

Q: What trade does Jennifer want to do?


Harris, Chapter 2 Trading StoriesA Retail Trade in a NYSE-listed Stock

Q: What does she do first?


Cincinnati Stock Exchange

Q: Why?


More on Consolidated Quotation System

Q: How are the bids sorted?


More on Retail Trade in NYSE-listed Stk.

Q: What instructions does Jennifer give to the broker?


More on Retail Trade in NYSE-listed Stk.

Broker enters the order, verifies Jennifer’s authorization to do this trade, verifies order, and submits it

Q: Why must the broker confirm that Jennifer is authorized to trade?


More on Retail Trade in NYSE-listed Stk.

Broker’s order system decides where to route order considering prices and payments

If sent to NYSE  goes via SuperDOT to specialist on trading floor who handles AT&T

Specialist tries to fill the limit order immediately or else places it on the Limit Order book


More on Retail Trade in NYSE-listed Stk.

Q: What happens next?


More on Retail Trade in NYSE-listed Stk.

  • Specialist enters price and volume in order reporting system, which notifies Consolidated Trade Reporting System – trades are reported worldwide

  • Q: What does the broker do next?


More on Retail Trade in NYSE-listed Stk.

  • Jennifer pays purchase price and broker’s commission

  • Q: Is that it? Or is there another step?


NBBO Example


A Retail Trade in a NASDAQ Stock

Q: What trade does Jennifer want to do on NASDAQ?


A Retail Trade in a NASDAQ Stock

  • Microsoft is traded by about 40 independent dealers on the NASDAQ

  • Jennifer calls a broker.

  • Broker reads a screen like Figure 2-2


More on a Retail Trade in a NASDAQ St.

(Looks very similar to Figure 2-1, except the quotes come from NASD market makers and ECNs, not separate exchanges)


More on a Retail Trade in a NASDAQ St.

Q:What instructions does Jennifer give to the broker?


More on a Retail Trade in a NASDAQ St.

  • Broker asks if she own shares to sell or wants to short-sell – in later case, the broker arranges to borrow shares

  • Broker submits order and order system routes the order to the NASDAQ Small Order Execution System (SuperSOES)

  • Broker may send it to a particular dealer who has agreed to provide a payment = “payment for order flow”

  • Dealer executes the trade at $55.97or better – must match the best bideven if not current quoting it

  • Broker confirms trade


An Institutional Trade in a NYSE Stock

  • Q: What is Bob’s position and company and who is the client he’s working for?


An Institutional Trade in a NYSE Stock

  • Example: 12:30 pm: Bob is asked to buy 400,000 shares of Exxon (current price = $40 / share) = 5% of average daily volume = not too difficult

  • If trading on short-term info  trade fast

  • In this case “fundamentally undervalued”  trade patiently


More on Institutional Trade in NYSE Stk.

  • Check info display for recent trades:

    • Falling prices may be selling pressure  good price for buy

    • Rising prices may be buying pressure  poor price for buy

  • Checks electronic exchanges (Bridge, Liquidnet, Autex, and Instinet) for buying interest vs. selling interest

    • Morgan Stanley indicates interest

  • Call NYSE floor trader and asks for current market conditions in Exxon  floor trader reports no large trader interest currently, but Morgan Stanley was selling earlier


More on Institutional Trade in NYSE Stk.

  • 12:50 pm: sends confidential buy order for 400,000 shares of Exxon to POSIT (POrtfolio System for Institutional Trading = an electronic exchange)

  • POSIT trades 8 times daily (9:40, 10, 10:30, 11, 12, 1, 2, 3) and tries to match buyers and sellers

  • price = (bid + ask) / 2 at random time in next 7 min

  • 1:10 pm: 48,000 shares of 400,000 filled at $39.84


More on Institutional Trade in NYSE Stk.

  • Calls sales trader at Morgan Stanley

  • client may want to sell more, Bob expresses interest

  • trade for 200,000 shares is negotiated at $39.87

  • call Morgan Stanley floor broker to “print the trade”

  • floor broker tells Exxon specialist he wants to cross a block of 200,000 at $39.87

  • specialist approves and trade is executed on the floor

  • other floor traders ask if there is additional trading interest


More on Institutional Trade in NYSE Stk.

  • Bob gives Merrill Lynch floor broker (market-not-held) 80,000 buy order to work at his discretion

  • Merrill floor broker stands in the crowd

  • Over next hour: buys 20,000 at $39.88, 32,000 at $39.90, 28,000 at $39.95

  • Gives Merrill floor broker remaining (market-not-held) 36,000 buy order

  • Merrill trades remaining 72,000 against specialist at $40.00


More on Institutional Trade in NYSE Stk.

Settlement is three days later


The Trading Industry Players

  • Q: What are these two “sides” of the market?


Players

  • Q: What are some examples of buy side investors?


Players

Q: What are some examples of sell side traders?


Properties of buy side vs. sell side


  • What is the distinction between real vs. financial assets?


Instrument Class


More on Instrument Classes

  • (Capital wealth is interesting = approximate market value of each class

  • Stocks are 20% vs. real estate is 50%

  • Q: Which gets more media attention?

  • Clearly stocks, but real estate is much bigger

  • Q: Why?

  • Far more trading in stocks

  • This class has disproportionate coverage of the equity markets

    • more data, rules, and information is publicly available

    • real estate, bonds, currencies, etc. are much more private

    • concepts in equities apply in other markets

    • will cover these other markets as possible


More on Instrument Classes

  • (Real estate is the opposite extreme – a huge amount of capital wealth, but super low trading frequency

  • Q: Why isn’t human capital on this list? Its bigger than everything on the list. Is this a mistake?


Markets


More on Markets

  • Q: Anything interesting in the Markets table?


International Stocks

  • Nearly every country has a stock market – you must have: flag, currency, and a stock market!

  • Q: Do you see any difference between stock markets in developed countries vs. emerging countries?


Futures Markets


More on Futures Markets


Regulators

Q: How many federal government regulators are there in the US?


Orders and Order Properties

  • Q: What is an order?


Orders and Order Properties

Q: What does an order always specify? What may an order specify?


Market Orders

Q: What are the key properties of a market order?


Market Orders

  • Suppose Bid = 30.00, Ask = 30.10

  • Consider a “round trip” trade:

  • Buy at 30.10 and then immediately sell at 30.00

  •  Cost = 30.10 – 30.00 = 0.10 = Bid-Ask Spread = Dollar Quoted Spread


More on Market Orders

  • Then we asked what if you trade at some other price?

  • Suppose you Buy at 30.08 and sell at 30.02

  •  Cost = 30.08 – 30.02 = 0.06 ≠ Dollar Quoted Spread


More on Market Orders

  • Now consider:

  • One-way trade = Buy at 30.08 now and plan to sell a year or two in the future

  • How can we think about the Cost of Trading? – we said Quoted Spread was not good enough, so we introduced Effective Spread – now let me give you a slightly different formula for effective spread:

  • Dollar Effective Spread

    = (Trade Price – Midpoint) * 2 for buys

    (Midpoint – Trade Price) * 2 for sells

    = (30.08 – 30.05) * 2 = .06


More on Market Orders

  • Dollar Effective spread

    = (Trade Price – Midpoint) * 2 for buys

    (Midpoint – Trade Price) * 2 for sells

    = (30.08 – 30.05) * 2 = .06

  • Q: What was the reason for times 2?


More on Market Orders

  • Intuitively, Effective Spread is the Cost of Trading based on actual Trade Prices

  • For the TAQ Project: approximated Effective Spread

    = | Trade Price – BBO Midpoint | * 2

  • Q: On the TAQ Project, why didn’t we use more exact formula for Effective Spread?


More on Market Orders

  • Can benefit from price improvement(i.e., trade inside the spread – example: ask = $30.10 & bid = $30.00, trade = $30.08 – more likely with small orders)

  • Can be hurt by walking the book(i.e., exercise the full quantity at the best price, then trade at 2nd best price, then at 3rd best price, etc.) much of the original trade executes outside the spread

  • Happens when: market buy > ask depth or market sell > bid depth – more likely with large orders


More on Market Orders

  • Summary of Market Order Properties:

    • Execution is certain

    • Price is uncertain


Limit orders

Now lets turn to limit orders

Suppose best ask = 32.10 and best bid = 32.00

Terms used to describe limit price placement


Limit orders

Q: Why called ”marketable”?


More on Limit Orders

  • “At the market” limit buys add liquidity at the current price

  • “In the market” limit buys create a new bid price with a tighter spread

  • “Behind the market” limit buys add liquidity for large orders

  • “At,” “In,” and “Behind” = Non-marketable limit orders

  • For limit buys, higher price is more Aggressivemore likely to execute, but at a worse price

  • For limit sells, lower price is more Aggressivemore likely to execute, but at a worse price


More on Limit Orders

Q: What are the key properties of a non-marketable limit order?


More on Limit Orders

Other properties of limit orders:

Limit orders may not execute (execution uncertainty) – happens when price move up on a LB and down on a LS – if price is “chased,” ultimate execution price may be poor

LOs may execute and loose money (ex post regret) – happens when price move down on a LB and up on a LS – need to monitor the market and cancel LOs to avoid trading at a “stale” price

LOs may execute and loose money to privately informed traders (adverse selection risk)


More on Limit Orders

  • Summary of Limit Order Properties:

    • Price is certain

    • Execution is uncertain


More on Limit Orders

Q: What is meant by validity and expiration instructions?


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