Chapter 6 Order-driven Markets
Order-driven markets • Most important exchanges are order-driven markets. • Most newly organized trading systems are electronic order-driven markets. • All order-driven markets use order precedence rule and trade pricing rule.
Examples of pure order-driven markets - Tokyo Stock Exchange, - KRX (previously KSE, KOSDAQ) - Paris Bourse, - Toronto Stock Exchange, - Most Future Markets, - Most European Exchanges for equities (Milan, Barcelona, Madrid, Bilbao, Zurich,….)
Types of order-driven markets • Oral auctions • Rule-based order matching systems • Single price auctions • Continuous order book auctions • Crossing networks
In order-driven markets, trading rulesspecify how trades are arranged: - order precedence rules: match buy orders with sell orders 1. Price priority 2. Time precedence or time priority • trade price rules: determine the trade price 1. Uniform pricing rule (single price auction) 2. Discriminatory pricing rule
Oral auctions • Used by many futures, options, and stock exchanges. • The largest example is the US government long treasury bond futures market (CBOT, 500 floor traders). • Traders arrange their trades face-to-face on an exchange trading floor. • Cry out bids and offers (offer liquidity) • Listen for bids and offers (take liquidity) • “Take it” = accept offer • “Sold” = accept bid
Open outcry rule – the first rule of oral auctions • Traders must publicly announce their bids and offers so that all other traders may react to them (no whispering…). • Traders must also publicly announce that they accept bids/offers. • Why is this necessary?
Order precedence rules • Price priority • Should a trader be allowed to bid below the best bid, above the best ask in an oral auction? • Time precedence • Is time precedence maintained for subsequent orders at the best bid or offer? Why? Why not? • How can a trader keep his bid or offer “live”? • The minimum tick size is the price a trader has to pay to acquire precedence. • Public order precedence • Why do you think this is necessary?
Trade pricing rule • Trades take place at the price that is accepted, i.e., the bid or offer. • Discriminatory pricing rule in oral auction. • Why do you think it is called discriminatory?
Trading floors • Trading floors can be arranged in several rooms as on the NYSE, with each stock being traded at a specific “trading post.” • Trading floors can also be arranged in “pits” as in the futures markets.
Rule-based order-matching systems • Used by most exchanges and almost all ECNs. • Trading rules arrange trades from the orders that traders submit to them. • No face-to-face negotiation. • Most systems accept only limit orders. • Why do you think most systems are reluctant to accept market orders?
Orders are for a specified size. • Electronic trading systems process the orders. • Trades may take place in a call, or continuously. • A new order arrival “activates” the trading system. • Systems match orders using order precedence rules, determine which matches can trade, and price the resulting trades.
Order precedence rules • Price priority • Market orders always rank above limit orders. • Limit buy orders with high prices have priority over limit buy orders with low prices • Limit sell orders with low prices have priority over limit sell orders with high prices.
Time precedence • Under time precedence, the first order at a given price has precedence over all other orders at that price. Gives orders precedence according to their time of submission. • The pure price-time rule uses only price priority and time precedence. • Floor time precedence to first order at price. All subsequent orders at that price have parity (Oral auction)
Display precedence • Why do markets use display precedence? • Size precedence • Some markets give precedence to small orders, other markets favor large orders (NYSE). • Public order precedence • Public orders have precedence over member orders at a given price.
Trades are arranged by matching the highest ranking buy orders with the highest ranking sell orders. • Order precedence rules are used to rank orders. • Order precedence rules vary across markets. However, the first rule is almost always price priority.
Trade pricing rules Single price auctions use the uniform pricing rule. Most continuous order-driven markets use the discriminatory pricing rule.
Uniform pricing rule • All matched orders are executed at the same price. • This rule is used for opening markets in many equities markets, following trading halts for many continuous markets, and in the AZX,….
Discriminatory pricing rule • In a continuous market trade takes place when an incoming order is matched with a standing limit order. • Under the discriminatory pricing rule, the trade price is the limit price of the standing limit order.
Example - What should be the price/prices? • Possibilities include: • Infinite • $20.05 • $20.06 • $20.08 • The price/prices depends on the trade pricing rules.
What should be the price/prices? • Single price auctions use the uniform pricing rule: • Everyone gets the same price. • Continuous two-sided auctions and a few call markets use the discriminatory pricing rule. • Trades occur at different prices. • Crossing networks use the derivative pricing rule. • The price is determined by another market.
Uniform pricing rule • All trades take place at the same “market clearing price.” • The market clearing price is determined by the last feasible trade. • Matching by price priority implies that this market clearing price is also feasible for all previously matched orders.
In Example 1, the last feasible trade is between Bev and Susie, so the market clearing price is $20.08. • Sam, Steve and Susie are happy with a market clearing price of $20.08 since they were willing to sell at $20.08 or lower. • Ben, Bob, and Bev are happy to with a market clearing price of $20.08 since they were willing to buy at $20.08 or higher.
If the buy and sell orders in the last feasible trade specify different prices, the market clearing price can be at either the price of the buy or the price of the sell order. • The trade pricing rules will dictate which one to use.
Supply and Demand • The single-price auction clears at the price where supply equals demand. • At prices below the market clearing price, there is excess demand. • At prices above the market clearing price, there is excess supply.
Single price auctions maximize the volume of trading by setting the price where supply equals demand. • Because prices in most securities markets are discrete, there is typically excess demand or excess supply at the market clearing price. • In the Example, what is the excess demand or supply?
The single price auction also maximizes the benefits that traders derive from participating in the auction. • Trader surplus for a seller = the difference between the trade price and the seller’s valuation • Trader surplus for a buyer = the difference between the buyer’s valuation and the trade price. • Valuations are unobservable, but we may assume that they at least are linked to limit prices.
Discriminatory Pricing Rule • Continuous two-sided auction markets maintain an order book. • The buy and sell orders are separately sorted by their precedence. • The highest bid and the lowest offer are the best bid and offer respectively.
When a new order arrives, the system tries to match this order with orders on the other side. • If a trade is possible, e.g., the limit buy order is for a price at or above the best offer, the order is called a marketable order. • If a trade is not possible, the order will be sorted into the book according to its precedence.
Discriminatory Pricing Rule • Under the discriminatory pricing rule, the limit price of the standing order dictates the price for the trade. • If the incoming order fills against multiple standing orders with different prices, trades will take place at multiple prices.
Discriminatory vs. uniform pricing rules • Taking the orders as given, large impatient traders (e.g., liquidity demanders: marketable limit orders) prefer the discriminatory pricing rule (to exploit better price). • Taking the orders as given, standing limit order traders (liquidity suppliers) prefer the uniform pricing rule (to maximize surplus).
However, orders are not given. • Limit order traders tend to price their orders more aggressively under the uniform pricing rule. • Can you explain this prediction? • Why would large traders want to split their orders when trading under the uniform pricing rule? • What role can trading halts have in affecting the pricing rules?
Continuous versus call markets • The single price auction produces a larger trader surplus than the continuous auction when processing the same order flow (example). • Concentration of order flow increases total trader surplus. • In practice, traders will not send the same order flow to call and continuous markets.
The single price auction will typically trade a lower volume than the continuous auction. • In our example, both trade 600 shares… • See textbook example (Table 6-7 & 6-8) • However, there is another benefit of the continuous market – it allows traders to trade when they state their demands.