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Dr. Michael Pagano, CFA Adapted from Slides by: Dr. Robert Schwartz © 2004 Baruch College and Wayne Wagner President, Plexus Group Market Structure, Trading, and Liquidity FIN 2340 Overview of Key Market Structure Topics Why Study Financial Market Structure?

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Market structure trading and liquidity fin 2340 l.jpg

Dr. Michael Pagano, CFA

Adapted from Slides by:

Dr. Robert Schwartz © 2004

Baruch College


Wayne Wagner

President, Plexus Group

Market Structure, Trading, and LiquidityFIN 2340

Slide2 l.jpg

Overview of Key Market StructureTopics

  • Why Study Financial Market Structure?

  • Overview of Market Structures & Trading Simulation

  • From Information to Prices

  • Liquidity Provision in Perfect & Imperfect Markets

  • Strategic Use of Limit and Market Orders

  • Market Intermediaries & the Evolution of Securities Markets

  • Institutional Order Flow

  • Algorithmic Trading and Technical Analysis

  • Trading Performance Measurement

  • Regulation

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Topics 1 & 2Getting a Grip on Trading

  • Customers (Investors & Issuers)

  • Brokers / Dealers

  • Market Centers (Listings / Order Flow / Data)

  • Benefits vs. Costs (Net Returns vs. Transaction Costs)

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or Market Maker

Fundamental Financing Channels


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U.S. Equity Market Centers

National Markets: NYSE, Nasdaq, Amex

Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia

Over-the-Counter Market (OTC)

Alternative Markets (ATSs, ECNs), e.g.:

INET (part of Nasdaq now)

Archipelago (part of NYSE Group now)

POSIT (Investment Technology Group)



The Equity Markets

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  • Investors

  • Asset Exchangers

  • Bluffers

  • Uninformed traders

  • Speculators

  • Dealers

  • Brokers

  • Exchanges

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Some Main Points to keep in mind

  • Traders who seek profit create liquidity and price efficiency.

  • Keep your eye on who has the information.

  • All profits ultimately must come from uninformed traders.

  • Comparative advantages and trading rules determine trader profits in the long run.

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  • Liquidity

  • Informative Prices

  • Volatility

  • Transaction Costs

  • Trading Profits

  • Net Investment Returns

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5 ¢ (17 bp)


10 ¢ (34 bp)


23 ¢ (77 bp)

Missed Trades

9 ¢ (29 bp)

  • The Iceberg of Transaction Costs

Source: Plexus Group, 2003

Cost components l.jpg

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% annual return over: 1, 5, and 10-year horizons?

Cost Components

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Getting a Grip on Trading (cont.)

  • Order Flow & Order Arrival Rates

  • Trading vs. Investing

  • Trader Types: Informed / Liquidity / Technical

  • Trading Simulation: Limit Order Books & Trading “Ecology”

  • Bid-Ask Spread & Limit vs. Market Orders

  • Liquidity (Time & Space) & Trading Performance

The two sides of the trading industry l.jpg

People and institutions who use market services are on the buy-side.

Those who provide market services are on the sell-side.

Both are customers of exchanges / markets.

These sides have nothing to do with whether you are a buyer or seller of a specific security.

The Two Sides of the Trading Industry

Buy side players l.jpg


Corporate pension fund sponsors

Charitable trusts

Legal trusts


Investment managers

Corporate investment funds

Insurance reserve funds

Governmental funds

Buy-Side Players

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Dealers trade for their own accounts.

Day Traders



Brokers trade for other people’s accounts.

Retail and institutional

Full-service and discount

Broker-dealers do both.


Wire houses

Sell-Side Players

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Market Centers provide systems that help traders arrange their trades.

Note that market centers and brokers often compete with each other.

Clearing houses help settle trades and guarantee that traders will perform (NSCC).

Depositories and custodians hold securities (DTC).

Sell-Side Trade Facilitators

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Goal of a Trading System

  • Bring customer orders together to make trades:

  • At reasonable cost

  • In a timely fashion

  • At reasonable prices

  • Success depends on quality of a market’s structure:

  • The systems, rules and protocols that determine how orders are handled and transformed into trades

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Order Flow





Is there a trend/





Is p*>offer

or p*<bid?

What Drives a Market?

3 Sources of Orders

Trading Mechanism

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The Big Problem

Enabling Buyers and Sellers, Large and Small, to Find Each Other

  • Two Dimensions

  • Place

  • Time

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Order Driven Market



10:50 10:55 11:00

The limit order book brings buyer& seller together


a Buy








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The Limit Order Book

Air Pocket

Bid – Ask Spread

(10.95 - 11.10)

Air Pocket

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P* and Best Bid and Offer Quotes




Day 1 Day 2

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Topics 3 & 4All About Liquidity

  • Gross vs. Net Investment Returns ($1100 vs. $1067)

  • Frictionless CAPM vs. Real-world Frictions

  • Info Types:

    • Market vs. Fundamental

    • Public vs. Private vs. Insider

  • Divergent Expectations and Adaptive Valuations

  • Liquidity: Depth / Breadth / Resiliency / Speed

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All About Liquidity (cont.)

  • Transaction Costs: Explicit vs. Implicit

  • Explicit: Commissions / Exchange Fees / Taxes

  • Implicit:

    • Bid-Ask Spread

    • Total Trading Cost = Delay + Impact + Opportunity Cost

  • Illiquidity & Transaction Costs affect:

    • Price Volatility (via bid-ask “bounce”)

    • Price Discovery

    • Quantity Discovery

    • Reduced portfolio net returns

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All About Liquidity (cont.)

  • Market Structure Types:

    • Continuous Order-Driven

    • Periodic Order-Driven Call Auctions

    • Continuous Quote-Driven (aka “Dealer markets”)

    • Negotiated Markets (e.g., ECN / ATS / block trader)

    • Hybrid Markets

  • Random Walk vs. Illiquid Market “Symptoms”:

    • Serial Return Correlation (Positive vs. Negative)

    • Time Scaling of Variance (e.g., Variance Ratio analysis)

    • Serial Cross-Return Correlation

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What Do the Following Have in Common?

Without Gas, Neither Will Run

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Order Flow is Gas 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”

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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).

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Price & Quantity Discovery

The most important objective of any market is to foster accurate price and quantity discovery

Much demand is latent – participants do not readily reveal their desires to buy or to sell

Traders instinctively know the price discovery problem. That is why technical analysis is widely used

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Price Discovery is Difficult Because


Cannot assess share values with precision

Have divergent expectations

Have adaptive valuations

Do analysts ever agree?

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Difficulty of Assessing Share Valuations With Precision

Can a stock analyst say with precision that the expected growth rate for XYZ is:

  • 7.00%, not

  • 7.55%?

Analyst evaluation of xyz l.jpg

Analyst Evaluation of XYZ

Dividend one year from now = $1.35

Appropriate cost of eq. cap. = 10%

(1) Growth rate (g) = 7.00%

(2) Growth rate (g) = 7.55%

Share price if g =7.00% = $45

Share price if g =7.55% = $55

Price determination l.jpg
Price Determination

V(H) = $55: The Bulls k percent

V (L) = $45: The Bears 1-k percent

What price(s) will prevail on the market?

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Order Driven Market



10:50 10:55 11:00

The limit order book brings buyer& seller together


a Buy








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The Limit Order Book

Air Pocket

Bid – Ask Spread

(10.95 - 11.10)

Air Pocket

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Dealer Intermediation





10:50 10:55 11:00

Dealer provision

of immediacy

brings buyer

& seller together





View from a market maker s desk l.jpg
View From a Market Maker’s Desk

Dealer Bid Dealer AskCOD 26.00 CAT 26.20DOG 26.00 COD 26.30TUNA 25.90 DOG 26.30CAT 24.80 TUNA 26.30

Order driven market l.jpg
Order Driven Market

Best Ask 100 shs @ $20.00

  • Last sale $15

Best Bid 200 shs @ $10.00

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Thin Order Book

Best Public Ask 100 shs @ $20.00

  • Mkt order: Sell 100

  • Sold @ $10

  • #*@$%**

  • Last sale $15

Best Public Bid 200 shs @ $10.00

Dealer specialist makes the market l.jpg
Dealer/Specialist “Makes” the Market

Best Public Ask 100 shs @ $20.00

Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95

  • Last sale $15

Best Public Bid 200 shs @ $10.00

Public trades with dealer l.jpg
Public Trades with Dealer

Best Public Ask 100 shs @ $20.00

Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95

  • Mkt order: Sell 100

  • Sold @ $14.95

  • 

  • Last sale $15

Best Public Bid 200 shs @ $10.00

Dealer is long 100 shares l.jpg
Dealer Is Long 100 Shares

Best Public Ask 100 shs @ $20.00

Specialist Ask 100 shs @ $15.05

Specialist Bid 100 shs @ $14.95 $14.90

Best Public Bid 200 shs @ $10.00

Slide46 l.jpg

A Call Auction



10:50 10:55 11:00

A meeting point

in time can bring multiple buyers & sellers together



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The Electronic Call Auction

  • Orders that could otherwise be matched and executed are held for a big, multilateral clearing.

  • Clearings are held at pre-determined points in time (i.e., once an hour).

  • All crossing orders are executed at a single price:

    • Buy orders at that price and higher execute

    • Sell orders at that price and lower execute

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The Batching of Customer Orders

O Offer

• Bid











How should these limit orders

be integrated to produce a good price?




1 2 3 4 5 6 No. Orders

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Cumulate The Buy Orders

• Individual buy order

 Cumulated buy orders at the price or better








1 2 3 4 5 6 No. Orders

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Cumulate The Sell Orders






• Individual sell order

O Cumulative sell orders

at the price or better



1 2 3 4 5 6 Orders

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Match Cumulated Buy & Sell Orders




P* =





1 2 3 4 5 6 Orders

Trading costs l.jpg
Trading Costs

1. Explicit costs

  • commissions

  • taxes

  • etc.

    2.Execution Costs (the implicit costs of trading)

  • Bid-ask spread

  • Market impact

  • Delay/Opportunity cost

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Trading Costs and Volatility

  • The bid-ask spread

  • Market impact

  • Momentum trading

  • Imperfect price discovery

Trading costs

cause prices to bounce between higher and lower values

Slide54 l.jpg



Trading Costs & Volatility


= Implicit transaction cost of buy or sell

= Transaction price (triggered by buy order)

= Transaction price (triggered by sell order)

= Magnitude of C

= Unobserved, costless trading price



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Trading Costs & Volatility


= Implicit transaction cost of buy or sell

= Observed price of buy-triggered trade

= Observed price of sell-triggered trade

= C

= Unobserved, costless trading price





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Trading Costs & Returns





Slide57 l.jpg

Trading Costs & Volatility

Which is more volatile:

P* or the transaction price we observe?







The efficient market hypothesis emh l.jpg

Existing information cannot be exploited to realize above normal (risk adjusted) trading profits

Weak form

information = historical market information

Semi-strong form

information = weak form + publicly available info

Strong form

Information = semi-strong form + private info

= the complete information set

The Efficient Market Hypothesis (EMH)

Random walk l.jpg
Random Walk

If the EMH holds

Security price changes (returns) are not serially correlated

Ri,t≠ f(ri,t-1)

Liquidity60 l.jpg

CAPM, the frictionless environment

2 dimensions: risk and return

Liquidity is perfect and a stock can be traded immediately at its equilibrium value (P*)

Actual markets

3 dimensions: risk, return, and liquidity

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Liquidity & Random Walk

  • Positive Intertemporal Correlation

  • Sequential information arrival

  • The limit order book

  • Market maker intervention

  • Inaccurate price discovery

  • Negative Intertemporal Correlation

  • Bid-ask spread

  • Market impact effects

  • Inaccurate price discovery

Serial Cross-Correlation

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The First 1/2 Hour



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The First 1/2 Hour

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Prices (P)

P0 , P1 , P2 , … , PT






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Arithmetic Returns (P)

P0,1 = P1 – P0

P1,2 = P2 – P1

PT-1,T = PT – PT-1

Slide66 l.jpg

Percentage Returns (r)

r0,1 = ( P1 – P0 ) / P0 = P0,1 / P0

r1,2 = ( P2 – P1 ) / P1 = P1,2 / P1

rT-1,T = ( PT – PT-1 ) / PT-1 = PT-1,T / PT-1

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Price Relatives (PR)

PR0,1 = P1 / P0 = ( P0 + P0,1 ) / P0 =1 + r0,1

PR1,2 = P2 / P1 = ( P1 + P1,2 ) / P1 = 1 + r1,2

PRT-1,T = PT / PT-1 = ( PT-1 + PT-1,T ) / PT-1 = 1 + rT-1,T

PR0,T = PT / P0 = (P1 / P0) * (P2 / P1) *…* (PT / PT-1)

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Log Returns (R)

R = ln(1+r) = ln(price relative)

R0,1 = ln(P1/P0)= ln(P1) – ln(P0) = ln(1+r0,1)

R1,2 = ln(P2/P1) = ln(P2) – ln(P1) = ln(1+r1,2)

RT-1,T = ln(PT) – ln(PT-1) = ln(1+rT-1,T)

PR0,T = PT / P0 = (P1 / P0) * (P2 / P1) *…* (PT / PT-1)

R0,T = R0,1 + R1,2 +…+ RT-1,T =

Ri-1,i = ln(PT) – ln(P0)

Slide69 l.jpg


Which of the following may be normally distributed?





Slide70 l.jpg

Two Period Log Returns

P2 = P0 ( 1 + r0,2 )

P2 = P0 ( 1 + r0,1 ) ( 1 + r1,2 )

1 + r0,2 = P2 / P0 = ( P1 / P0 ) * ( P2 / P1 ) =

= ( 1 + r0,1 ) ( 1 + r1,2 )

R0,2 = R0,1 + R1,2

Slide71 l.jpg

Log Returns: Two Period Mean

Assume constant Mean:

E(R0,1) = E(R1,2)

E(R0,2) = E(R0,1) + E(R1,2)

E(R0,2) = 2E(R0,1)

Slide72 l.jpg

Log Returns: Two Period Variance


Assume constant Variance:

Var(R0,1) = Var(R1,2)

For Cov(R0,1,R1,2) = 0

Var (R0,2) = 2 Var(R0,1)

What if Cov(R0,1,R1,2) < 0 ?

Key statistical measures l.jpg
Key Statistical Measures

  • Mean Return (via ln of Price Relative)

  • Variance and S.D. of Returns

  • Market Model Beta, R2, and Residual Variance.

  • Variance Ratio = Var (R0,2) / [2 * Var (R0,1)]

  • Volume-Weighted Average Price =

    VWAP0,T = t=1,T wt * Pt

    where, wt = Sharest / t=1,T Sharest

Additional measures l.jpg

Quoted Spread = (Ask – Bid)

Effective Spread = 2 * (B/S) * (Pt – Quote Midpointt)

Quote Midpoint = (Ask + Bid) / 2

Realized Spread = 2 * (B/S) * (Pt – QMPt+n)

Tot. Trans. Cost = Delay + Impact + Missed Trades

Implementation Shortfall =

Beginning Portfolio Value – Ending Portfolio Value

Additional Measures

Slide75 l.jpg

Topic 5How to use Limit and Market Orders

  • Limit Order Books / Market Makers / Hybrids

  • Key Order Types:

    • Limit orders: “make” liquidity / “patient”

    • Market orders: “take” liquidity / “impatient”

    • Stop Loss & Stop Limits: manage risk

  • Limit Orders: ↓ Impact vs. ↑ Delay

  • Limit Order Risks: Execution Risk and “Bagging”

  • Price & Time Priority Rules reduce risk somewhat

Slide76 l.jpg

How to use Limit and Market Orders (cont.)

  • Break-even Probability of Limit vs. Market Orders

    ProbB-E = (Preserve - Pmarket) / (Preserve - Plimit)

  • Expected Gain = Probactual * (Preserve - Plimit)

  • Equilibrium B-A spread size is determined by “Gravitational Pull” concept of limit vs. market

  • Option Value of a Limit Order:

    • Bid Limit order = “short Put” (must buy from a seller)

    • Ask Limit order = “short Call” (must sell to a buyer)

    • The “Premium” received from these sales = B-A spread

Slide77 l.jpg

Limit orders be posted

Market orders be submitted

Ecology of a Pure Order Driven Market

Participants meet to establish prices and trade. This requires:

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Assume I have an open, unexecuted buy limit order on the book. If a news event occurs, it’s …

"Heads You Win, Tails I Lose”

Informational Change

  • Heads You Win: Bearish news has caused the price of the stock to fall and my limit order executes

  • Tails I Lose: Bullish news has caused the price of the stock to rise and my limit order doesn’t execute

So Why Did I Place That Limit Order?

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A book. If a news event occurs, it’s …liquidity event that results in a price decline could cause my buy limit order to execute.

After being driven down, price would revert back up.

I profit as price mean reverts after my order has executed.

Sufficient mean reversion can offset the costs that result from informational change.

Compensation From a Liquidity Event

Mean Reversion = Accentuated Volatility

They are the same thing!

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Compensation for book. If a news event occurs, it’s …

Risk of adverse informational change

Risk of limit order not executing

Bid-Ask Spread

Gravitational Pull Effect

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Market Ask book. If a news event occurs, it’s …

Market Bid

Potential Buy Order 2

Potential Buy Order 1

Gravitational Pull

Slide82 l.jpg

Making the Trade book. If a news event occurs, it’s …

(based on Navarro chapters)

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The Stock Market and Business Cycles book. If a news event occurs, it’s …

  • Stock Market is a leading economic indicator

  • Different Sectors shine at various points during the business cycle.

  • Early / Middle / Late Bull Markets:

    Transportation / Capital Goods / Commodities

  • Early / Middle / Late Bear Markets:

    Consumer Staples / Utilities / Cons. Cyclicals

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The Interest Rate Cycle & Yield Curve book. If a news event occurs, it’s …

  • Yield Curve can be a Leading indicator of both the Stock Market and Economy.

  • Federal Reserve sets short-term rates but…

  • Long-term rates set by investor expectations of economic growth and inflation.

  • Bonds and Money Market instruments can be competitors to Stocks.

  • Normal / Steep / Inverted / Flat Yield Curves:

    Middle Bull / New Bull / Bearish / Mixed

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Managing Risk book. If a news event occurs, it’s …

  • 3 Key Risks: Market, Sector, Company.

  • Compute Reward-to-Risk Ratio for your trades / stocks:

    Ad hoc Rule of Thumb (3:1), Sharpe Ratio, Alpha, Beta.

  • Diversification is very important (e.g., “no more than 20% in one sector”).

  • “Never bet the farm!”

  • “When in doubt, go flat.”

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Managing Trade Execution book. If a news event occurs, it’s …

  • Market vs. Limit Orders

  • Trading Range vs. Trending Markets

  • Intelligent Stop Loss orders:

    • Set “loose stops”

    • Avoid round numbers & technical nodes

    • Use “trailing stops” to lock in gains

  • “Never turn a winner into a loser”

  • “Never average down a loss”

  • “Never churn your own portfolio”

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Topics 6 & 7 book. If a news event occurs, it’s …Market Intermediaries: Nuts & Bolts

  • Broker vs. Dealer vs. Specialist

  • Blurring of Lines between:

    • Sell-side vs. Buy-side

    • Securities Exchanges vs. ECNs vs. ATSs

  • NYSE Specialist vs. Nasdaq Mkt Maker vs. ECN / ATS

  • NYSE Specialist: Positive & Negative Obligations

  • Nasdaq MM: Proprietary dealers change quotes depending on their inventory position: ↑ B-A if INV < 0

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Market Intermediaries: Nuts & Bolts book. If a news event occurs, it’s …(cont.)

  • Institutional Order Flow (Large Peg vs. Small Hole) and Institutional Investors’ responses:

    • “Slicing and Dicing”

    • Greater control over order-routing (incl. “preferencing”)

    • Increased use of ECN and ATS services

  • Market Maker (MM) Services: Immediacy / Liquidity / Animation / Price Discovery / P & Q Improvement

  • MM Revenues: B-A spread / Trading Order Flow / Commissions

  • MM Costs: Inventory Mgmt / Asymmetric Info / Order Processing = f (INV, AI, KL) / Q

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The Eye of the Storm book. If a news event occurs, it’s …

  • The institutions are huge

  • Markets are structured for retail order flow

  • How can the big guys get the liquidity they need?

Big Pegs and Tiny Holes

  • Dealer capital

  • Place limit orders

  • Trade negotiation

  • Not held (NH) orders

  • Slice, dice and shred

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* book. If a news event occurs, it’s …

* Remarks made at Baruch Conference, Coping With Institutional Order Flow, NYC, April 29, 2003

Remarks from John Phinney

  • To a retailinvestor, the stock exchanges look like a vending machine!

  • This is not the case for the institutional trader. As we know, the “peg” of institutional trading interest is much larger than the “hole” size of the exchange process.

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Remarks from John Phinney book. If a news event occurs, it’s …(cont.)

  • The “meat grinder” appears clearly in all of our data sampling.

  • Trading costs seem to be much more related to endogenous market factors, structure, and process, than to exogenous factors derived from investor behavior.

Slide92 l.jpg

Phinney’s Meat Grinder Example book. If a news event occurs, it’s …

1.8 Million Buy Order for Oracle, August 15, 2002


Number: 1,000+

Average size: 1,700 shares

Largest : 64,000 shares

Smallest: 13 shares

1000 shares or less 61% of execs

100 shares or less: 17% of execs

Time to complete: 51 minutes

Slide93 l.jpg

Phinney’s Conclusion book. If a news event occurs, it’s …

It was a DFT

It required a 1,000-to-1 reduction of the manager’s intent (and a significant amount of technology) to get trade pieces small enough to be digestible by the market.

Market maker services l.jpg

Immediacy book. If a news event occurs, it’s …

Supplemental liquidity

Price discovery


Market Maker Services

Immediacy l.jpg
Immediacy book. If a news event occurs, it’s …

  • Market maker practices are designed to facilitate the rapid execution of customer orders

  • However, orders are commonly traded patiently (i.e., without immediacy)

    • Upstairs negotiation of large block trades

    • Breaking up large orders for submission over time

    • Limit orders

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Inventory cost: book. If a news event occurs, it’s … Cost of carrying unbalanced inventory

Processing cost: Cost of labor, physical capital required to execute trades

Information cost: Cost of trading with better informed participant

Spread = f (INV, KL, AI) / Q

Market Maker Costs

What makes a market maker successful l.jpg

Inventory control book. If a news event occurs, it’s …

Trading the order flow carefully

Ability to hide/disguise large positions

Knowledge of customers (source of the order flow) is also important in practice

What Makes a Market Maker Successful?

Inventory control in traderex l.jpg
Inventory Control in TraderEx book. If a news event occurs, it’s …

  • If P* jumps above your offer, your customers will, on net, be buyers and your inventory will fall

  • As your inventory falls, you raise your bid and offer

  • The higher bid attracts sellers and the higher offer discourages buyers

  • What happens to your inventory if your bid is raised above P*?

Your inventory is controlled by adjusting your bid and offer relative to the unobserved P*

Transparency l.jpg

"Shares sold to a market maker are still for sale” book. If a news event occurs, it’s …


As a Market Maker,

How Transparent Do You Want the Market To Be?

After you acquire a large inventory in the process of servicing a customer, you must work off that position

You do not want your inventory revealed by a trade publication

So how do market makers compete l.jpg

Knowing their customers book. If a news event occurs, it’s …

Offering an array of services

Developing customer relationships; this results in


Quote matching

A market spread that is greater than it would be in an order-driven environment

So, How Do Market Makers Compete?

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Topic 8 book. If a news event occurs, it’s …The Road to Tech. Analysis & Algo Trading

  • Dynamic Price Discovery due to:

    • Large, complex information set

    • Divergent expectations and Adaptive valuations

  • Quantity Discovery problems due to:

    • Institutional Order Flow and Bifurcation of P & Q discovery

    • Bookbuilding problem and Trade Clustering

  • Technical Analysis to increase trading profits: S-T timing / “Trade the OF” / B-A Bounce vs. Momentum

  • Algo Trading to reduce trading costs: automates “slicing & dicing”, “VWAP trades”, etc.

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Some Observations book. If a news event occurs, it’s …

  • Trading occurs in bursts (trade clustering).

  • The bursts are commonly 2-sided.

  • But the large orders are not meeting each other efficiently.

  • There is a large latent demand to trade.

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Big Trades Cluster in Time book. If a news event occurs, it’s …

Two-Sided Clusters Are Common for Big Orders

Some Conclusions

This implies that

Institutional Orders are Portable in Time

Much Institutional Demand isLATENT

Market Structure Objective:

Bring Hidden Liquidity

“In From The Cold”

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Some Technical Analysis Techniques book. If a news event occurs, it’s …

  • Moving Averages

  • MACD and Cross-overs

  • Trendlines and Break-outs

  • Relative Strength (RSI)

  • Stochastics / Oscillators

  • Pattern Recognition (e.g., “head & shoulders”, “pennants”, etc.)

  • Point and Figure charts

  • Candlestick charts

  • Volume and Market Breadth

  • Money Flow statistics

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Background book. If a news event occurs, it’s …

Market Maker Operations

Floor Broker Intermediation

Algorithmic Trading

Algorithmic Trading

An electronic intermediary

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Floor based trading and NH orders book. If a news event occurs, it’s …

Which is Smarter?


  • Electronic systems and algorithmic trading

Kasparov vs. Deep Blue

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The Raison d’être of Algorithmic Trading book. If a news event occurs, it’s …

  • Dynamic price discovery

  • The speed with which events can occur

  • Exploit Market inefficiencies to ↓ costs

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Topics 9 & 10 book. If a news event occurs, it’s …Trading Performance Measurement

  • Key Measures: P&L / Trading Surplus / Benchmarks (VWAP & Implementation Shortfall)

    P&L = Cash Position + (Open Position * Bid Price)

    Trading Surplus = (Preserve - Ptransaction) * Quantity

    VWAP0,T = t=1,T wt * Pt

    where, wt = Sharest / t=1,T Sharest

    IS = (B/S) * [(QMP0 - QMPt) + (Avg. QMPt,T – Avg. Pt,T) + (% Unfilled * (QMP0 - PT))]

    where, 0 = time of initial request / t = first trade / T = last trade

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Trading Performance Measurement book. If a news event occurs, it’s …(cont.)

  • Transaction Cost Analysis (TCA) typically focuses on Implementation Shortfall (IS) plus trading commissions to measure Total Trading Costs (TTC).

  • Risk Management vs. Transaction Costs (e.g., limit orders might lower cost but increase market risk).

  • Best Execution:

    • Analyze processes vs. individual trades

    • Soft Dollars and Agency conflicts

    • New Regulatory Environment: MiFID in Europe and Reg NMS in the U.S.

    • Market Centers’ responsibilities in this new environment

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Best Execution book. If a news event occurs, it’s …

  • 1975 Security Acts Amendments

  • Retail vs. institutional order flow

  • Execution price vs

    • Speed

    • Certainty

    • Anonymity

    • Control

    • Etc.

  • An order is multi-dimensional.

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A book. If a news event occurs, it’s …snapshot assessment for a single, no brainer order?

– What about orders that are sliced & diced?

– Order that are market timed?

Beating a performance benchmark?

Quality of procedures followed?

None of the above?

Best Execution is better thought of as a process.

What is Best Execution?

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Soft dollar commitments book. If a news event occurs, it’s …

Use of an erroneous benchmark

Excessive pressure to trade quickly

Imperfect market structure

Impediments to Best Execution

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Heart of the Problem book. If a news event occurs, it’s …

Soft Dollars

Outsourcing research, computer systems, and other support services to sell-side with client assets used as payments => Agency Problem!

(The costs are hidden)

Commission Bundling

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Soft Dollar Commissions and Preferencing book. If a news event occurs, it’s …

Best Execution procedures

Reg NMS and the nature of competition

Level Playing Field: NYSE, Nasdaq, ECNs

Transparency and Market Access

Fairness for Retail vs. Institutional Investors

Rate of Technological Innovation

Key Regulatory Topics