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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
Dr. Michael Pagano, CFA

Adapted from Slides by:

Dr. Robert Schwartz © 2004

Baruch College

and

Wayne Wagner

President, Plexus Group

Market Structure, Trading, and LiquidityFIN 2340
slide2

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
slide3

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)
slide4

Firm

Investor

IB / CB

Firm

Investor

Buyer

Seller

Agent

Exchange

or Market Maker

Fundamental Financing Channels

Agent

the equity markets
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)

Liquidnet

Pipeline

The Equity Markets
slide6

Trading Players

  • Investors
  • Asset Exchangers
  • Bluffers
  • Uninformed traders
  • Speculators
  • Dealers
  • Brokers
  • Exchanges
slide7

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.
slide8

Major Trading Issues

  • Liquidity
  • Informative Prices
  • Volatility
  • Transaction Costs
  • Trading Profits
  • Net Investment Returns
slide9

Commission

5 ¢ (17 bp)

Impact

10 ¢ (34 bp)

Delay

23 ¢ (77 bp)

Missed Trades

9 ¢ (29 bp)

  • The Iceberg of Transaction Costs

Source: Plexus Group, 2003

cost components
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
slide15

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
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
Individuals

Corporate pension fund sponsors

Charitable trusts

Legal trusts

Endowments

Investment managers

Corporate investment funds

Insurance reserve funds

Governmental funds

Buy-Side Players
sell side players
Dealers trade for their own accounts.

Day Traders

Scalpers

“Locals”

Brokers trade for other people’s accounts.

Retail and institutional

Full-service and discount

Broker-dealers do both.

Specialists

Wire houses

Sell-Side Players
sell side trade facilitators
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
slide20

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
3 sources of orders

Liquidity

Order Flow

Informed

Technical

Trading

P*

Is there a trend/

pattern?

Quotes,

Prices,

Volume

Is p*>offer

or p*<bid?

What Drives a Market?

3 Sources of Orders

Trading Mechanism

slide22

The Big Problem

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

  • Two Dimensions
  • Place
  • Time
slide23

Order Driven Market

Public

Seller

10:50 10:55 11:00

The limit order book brings buyer& seller together

Places

a Buy

Limit

Order

Limit

Order

Executes

Public

Buyer

slide24

The Limit Order Book

Air Pocket

Bid – Ask Spread

(10.95 - 11.10)

Air Pocket

slide26

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
slide27

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
slide28

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
what do the following have in common
What Do the Following Have in Common?

Without Gas, Neither Will Run

order flow is gas for a market
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”

liquidity
Liquidity

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).
price quantity discovery

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

price discovery is difficult because

Price Discovery is Difficult Because

Investors

Cannot assess share values with precision

Have divergent expectations

Have adaptive valuations

Do analysts ever agree?

difficulty of assessing share valuations with precision

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

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
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?

slide37

Order Driven Market

Public

Seller

10:50 10:55 11:00

The limit order book brings buyer& seller together

Places

a Buy

Limit

Order

Limit

Order

Executes

Public

Buyer

slide38

The Limit Order Book

Air Pocket

Bid – Ask Spread

(10.95 - 11.10)

Air Pocket

slide39

Dealer Intermediation

Public

Seller

Dealer

Sells

10:50 10:55 11:00

Dealer provision

of immediacy

brings buyer

& seller together

Public

Buyer

Dealer

Buys

view from a market maker s desk
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
Order Driven Market

Best Ask 100 shs @ $20.00

  • Last sale $15

Best Bid 200 shs @ $10.00

thin order book
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
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
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
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

A Call Auction

Public

Seller

10:50 10:55 11:00

A meeting point

in time can bring multiple buyers & sellers together

Public

Buyer

slide47

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
slide48

The Batching of Customer Orders

O Offer

• Bid

Price

52

O

O

51

O

50

49

O

Question

How should these limit orders

be integrated to produce a good price?

48

O

47

1 2 3 4 5 6 No. Orders

slide49

(1)

(1+2=3)

(3+1=4)

(4+1+5)

(5+1=6)

Cumulate The Buy Orders

• Individual buy order

 Cumulated buy orders at the price or better

Price

52

51

50

49

48

47

1 2 3 4 5 6 No. Orders

slide50

O

(5)

(4)

O

(3)

O

O

(2)

(1)

O

Cumulate The Sell Orders

Price

52

51

50

49

• Individual sell order

O Cumulative sell orders

at the price or better

48

47

1 2 3 4 5 6 Orders

slide51

CUMULATED

SELL ORDERS

O

O

O

50

O

O

CUMULATED

BUY ORDERS

3

Match Cumulated Buy & Sell Orders

Price

52

51

P* =

50

49

48

47

1 2 3 4 5 6 Orders

trading costs
Trading Costs

1. Explicit costs

  • commissions
  • taxes
  • etc.

2.Execution Costs (the implicit costs of trading)

  • Bid-ask spread
  • Market impact
  • Delay/Opportunity cost
slide53

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

Price

Time

Trading Costs & Volatility

C

= 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

P*

P*

slide55

Trading Costs & Volatility

C

= Implicit transaction cost of buy or sell

= Observed price of buy-triggered trade

= Observed price of sell-triggered trade

= C

= Unobserved, costless trading price

P*

Price

P*

Time

slide56

Trading Costs & Returns

Price

P

T

Time

slide57

Trading Costs & Volatility

Which is more volatile:

P* or the transaction price we observe?

Price

P*

Observed

Transaction

Price

Time

the efficient market hypothesis emh
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
Random Walk

If the EMH holds

Security price changes (returns) are not serially correlated

Ri,t≠ f(ri,t-1)

liquidity60
Liquidity

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

slide61

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

slide62

The First 1/2 Hour

INTRADAY VOLATILITY

NYSE

slide63

INTRADAY VOLATILITY

LONDON STOCK EXCHANGE

The First 1/2 Hour

slide64

Prices (P)

P0 , P1 , P2 , … , PT

Time

P0

P1

P2

PT

slide65

Arithmetic Returns (P)

P0,1 = P1 – P0

P1,2 = P2 – P1

PT-1,T = PT – PT-1

slide66

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

slide67

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)

slide68

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

Question:

Which of the following may be normally distributed?

P

r

PR

R

slide70

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

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

Log Returns: Two Period Variance

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

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
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
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

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

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
Limit orders be posted

Market orders be submitted

Ecology of a Pure Order Driven Market

Participants meet to establish prices and trade. This requires:

slide78
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?

slide79
A 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!

slide80
Compensation for

Risk of adverse informational change

Risk of limit order not executing

Bid-Ask Spread

Gravitational Pull Effect

slide81
Market Ask

Market Bid

Potential Buy Order 2

Potential Buy Order 1

Gravitational Pull

slide82

Making the Trade

(based on Navarro chapters)

slide83

The Stock Market and Business Cycles

  • 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

slide84

The Interest Rate Cycle & Yield Curve

  • 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

slide85

Managing Risk

  • 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.”
slide86

Managing Trade Execution

  • 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”
slide87

Topics 6 & 7Market 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
slide88

Market Intermediaries: Nuts & Bolts (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
slide89

The Eye of the Storm

  • 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
slide90

*

* 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.
slide91

Remarks from John Phinney (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

Phinney’s Meat Grinder Example

1.8 Million Buy Order for Oracle, August 15, 2002

Executions

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

Phinney’s Conclusion

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
Immediacy

Supplemental liquidity

Price discovery

Animation

Market Maker Services
immediacy
Immediacy
  • 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
market maker costs
Inventory cost: 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
Inventory control

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
Inventory Control in TraderEx
  • 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
"Shares sold to a market maker are still for sale”Transparency

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
Knowing their customers

Offering an array of services

Developing customer relationships; this results in

Preferencing

Quote matching

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

So, How Do Market Makers Compete?
slide101

Topic 8The 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.
slide102

Some Observations

  • 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.
some conclusions
Big Trades Cluster in Time

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”

slide104

Some Technical Analysis Techniques

  • 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
slide105
Background

Market Maker Operations

Floor Broker Intermediation

Algorithmic Trading

Algorithmic Trading

An electronic intermediary

slide106
Floor based trading and NH orders

Which is Smarter?

Or…

  • Electronic systems and algorithmic trading

Kasparov vs. Deep Blue

slide107

The Raison d’être of Algorithmic Trading

  • Dynamic price discovery
  • The speed with which events can occur
  • Exploit Market inefficiencies to ↓ costs
slide108

Topics 9 & 10Trading 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

slide109

Trading Performance Measurement (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
slide110

Best Execution

  • 1975 Security Acts Amendments
  • Retail vs. institutional order flow
  • Execution price vs
    • Speed
    • Certainty
    • Anonymity
    • Control
    • Etc.
  • An order is multi-dimensional.
what is best execution
A 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?
impediments to best execution
Soft dollar commitments

Use of an erroneous benchmark

Excessive pressure to trade quickly

Imperfect market structure

Impediments to Best Execution
heart of the problem
Heart of the Problem

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

key regulatory topics
Soft Dollar Commissions and Preferencing

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
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