Research in the Area of Market Microstructure

J.C. LinCollette Endowed Chair of Financial Services and Professor

Louisiana State University

Prepared for Presentation at University of Vaasa, Finland

October 2004

What Are the Issues?

One security, many markets: Market integration? Exchange regulation: Do trading halts reduce or

increase price volatility? Market structure: What may happen in a market with

multiple dealers? Competition or collusion? Market quality: Trading cost? Determinants of bid-ask spread: Adverse selection,

order processing, and inventory holding cost?

What are the issues?(continued)

Dealer Competition: Does the number of market makers matter? How to prove it?

Upstairs market: Why is there a need for one?

Market interdependence: Where would you go if you have private information? Lead-lag relation?

A Field Exam Question

Many studies have examined whether trade location matters in pricing securities. Address and cite empirical findings to indicate what differences may exist, in terms of price execution, liquidity, and price discovery, with respect to the following conditions:

a) NYSE-listed stocks simultaneously traded on the NYSE, NASDAQ, and

regional exchanges;b) similar securities but traded in different markets, e.g., the NYSE vs. the

NASDAQ;c) securities moved from one market to another market;d) same securities traded in the upstairs market (i.e., in-house trading

rooms of dealers/brokers) vs. the downstairs market (i.e., exchange floors).

Market Integration and Price Execution for NYSE-Listed Securitiesby Charles Lee, 1993, JF

For securities traded simultaneously in two or more markets, the market integration—the full and timely communication of intermarket information—is an issue of practical, academic, and regulatory importance.

Why??

Importance of market integration

Fully integrated markets can lower the cost and time delay of trading, and enhance price efficiency.

In poorly integrated markets, the choice of where an order is routed can have a significant effect on the price obtained.

What and how to test for market integration?

Intermarket Trading System, ITS

Most NYSE-listed securities also trade on regional exchanges and the OTC market.

The ITS links these markets together, by disseminating trades and quote revisions to all locations.

In U.S. equity markets, dealers must meet or beat the ITS quote.

Are these market fully integrated?

If not, what factors may cause the problem?

A possible factor:Payment for order flows

OTC dealers and regional specialists may pay brokers cash rebates, typically one cent per share, for directing customers’ orders to their market centers.

Is the fiduciary responsibility of brokers to procure “best execution” for customers compromised by the payment for order flows?

It is an issue of regulatory importance.

Conflicts of interest?

Maintaining brokers’ primary responsibility to their customers even in the presence of side payments?

Either way, the result would be interesting.

Three tests

Liquidity premium test: compare liquidity premium paid on off-Board trades to that paid on adjacent NYSE trades.

– Liquidity premium is defined as the absolute difference between the trade price and the midpoint of the bid-ask spread.

Trade price test: compare the trade price of off-Board buys (or sells) to adjacent NYSE buys (or sells).

Price improvement test: compare the likelihood of price improvement over the quoted prices by documenting the frequency of inside-the-spread trading across the different exchanges.

For all three tests, off-Board trades are matched against NYSE trades

of similar size in the same security executed within two minutes.

Results

The first test shows that liquidity premiums are typically lower at NYSE, Midwest, and Cincinnati regional exchanges, and higher at the OTC market.

The second test shows that investors tend to pay lower prices for buys and obtain higher prices for sells on the NYSE relative to adjacent off-Board trades.

– The average price difference is about 0.7 to 1 cent, comparable to the typical cash rebates in payment for order flow agreements.

The third test shows that the market centers with the most frequent inside-the-spread executions—NYSE, Midwest, and Cincinnati—also had the most favorable prices.

Implications

The location of execution is price relevant.

Even with the ITS, the U.S. equity markets are not fully integrated.

Brokers’ responsibility to customers appears to be compromised by payments for order flows.

Caveats

To evaluate dealer services, trade price is just one of many factors, e.g., the speed of execution, guaranteed depth, reliability of trade settlement.

Causality seems to flow from location to price performance, but the reverse could also hold.

– For example, trades may be sent to a regional exchange only when it provides the best price.

– It does not explain the NASD results, since trades seem to be sent to there in spite of inferior price performance

Price improvement could occur at the expense of public limit orders. – Would limit-order traders be better off at NYSE or the OTC??

Future research??

Volume, Volatility, and New York Stock Exchange Trading Haltsby Lee, Ready and Seguin, JF 1994

After the 1987 market crash, “circuit breakers” that halt trading on exchanges have been proposed.

Proponents: During major price changes there can be a breakdown in the transmission of information between the trading floor and market participants.

– Trading halts provide an opportunity to reinform participants. – By lowering informational asymmetries between traders, halts could lead to

orderly emergence of a new consensus price.

Opponents: Not only do halts impose a liquidity cost on traders, but studies suggest that information will not be as readily revealed during a halt as through continuous trading.

Who do make more sense?

NYSE Trading Halts

NYSE trading halts are called during “unusual market situations.”

– Order imbalance halts, reflecting imbalance in the buy-sell direction of orders that cannot be resloved immediately.

– News pending halts, usually arising from information, provided by listed corporations, that might have a significant price effect.

Trading halts provide a rare opportunity to examine the effect of circuit breakers in a period of large rapid price adjustment.

Price Discovery During a Trading Halt

During a halt, the specialist engages in price exploration by issuing indicator quotes.

– lower and upper bounds for the probable reopening price.– Potential buyers and sellers respond by placing

commitments to trade on either side of the market.– These commitments can be withdrawn or changed during

the halt.– The reopening is a call auction where existing commitments

are matched.

Research Design

Use intraday data and precise announcement times to compare volume at the reopening and volume and volatility in the posthalt period to statistics associated with “pseudohalt” for the same firm.

A pseudohalt is a control period of continuous trading for the same firm, matched on time and duration.

Findings

Trading halts do not reduce either trading volume or price volatility.

Contrary to what might be expected after the emergence of a consensus price, the period after a trading halt is characterized by higher levels of both volume and volatility.

Volume (volatility) in the full trading day after a halt is 230% (50 to 115%) higher than following “pseudohalts.”

Higher posthalt volume is observed into the third day, while higher posthalt volatility decays within hours. (Why?? Media coverage? Portfolio rebalance? Learning from trading?)

Other Benefits of Halts

Although halts do not generally achieve the objective of creating a calming down period, there are other benefits.

Halts reduce the amount of disequilibrium trading that would

otherwise take place during a period of price adjustment. – To the extent that this is desirable, halts convey an economic

benefit.

Halts “indemnify” liquidity suppliers from losses due to extreme price movement.

– Liquidity suppliers, including limit order traders and specialists, may be willing to supply liquidity at lower cost knowing that halts will be called in the event of a major price move.

Caveat

The price path during a halt is not observable. Thus, it is difficult to evaluate the benefits of the price volatility avoided by calling the halt.

Future research??

Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?By Christie and Schultz (1994, JF)

Provide empirical evidence on the degree of competition among dealers who make markets in the NASDAQ system.

– Several hundred firms act as dealers in the system.– The number of market makers per stock ranges from 2 to

over 50.– Free entry and exit.

In such a market, competitive spreads might be considered a natural outcome.

However, their results suggest otherwise.

Basic Findings

Examine the entire distribution of dollar spreads using an extensive sample of inside bid and inside ask quotes for 100 of the most active NASDAQ stocks in 1991.

Spreads of one-eighth are virtually nonexistent for a majority of this sample.

The lack of one-eighth spreads can be traced to an absence of either inside bid or inside ask quotes ending in odd-eighths (1/8, 3/8, 5/8, and 7/8) for 70 of the 100 stocks.

In contrast, a sample of 100 NYSE and AMEX firms of similar price and market value to the NASDAQ sample consistently use the full spectrum of eighths.

Implications

The absence of odd-eighth quotes for the majority of the NASDAQ sample implies an inside spread of at least $0.25.

The result might reflect an implicit agreement among market makers to avoid using odd-eighths in quoting bid and ask prices.

Furthermore, a large number of market makers per stock is not necessarily synonymous with competition.

Market Structure: NYSE vs. NASDAQ

The NYSE or AMEX specialist is awarded an exclusive franchise to act as a dealer and auctioneer in each stock.

In return, specialists are closely regulated and are bound by an affirmative obligation to maintain a “fair and orderly market.”

– They face competition for order flow from floor traders on the exchange, from other exchanges, and from public limit orders;

– Limit order prices are part of the spread displayed to the market and take precedence over specialists’ trades for their own account.

In contrast, NASDAQ dealers do not have an exclusive franchise to make a market in a stock and are not as closely regulated.

– They must provide firm quotes on both sides of the spread with a depth of at least 1,000 shares per dealer.

The two markets could differ in their effectiveness in promoting competitive spreads.

Market Structure: NYSE vs. NASDAQ

The fundamental premise of the NASDAQ system is that competition for order flow among dealers will produce narrow spreads.

In contrast to the NYSE, NASDAQ limit orders are not exposed to the public and are executed if and only if the inside spread reaches the limit price.

Thus, the public cannot use limit orders to compete directly with NASDAQ market makers, and inside quotes do not reflect the presence of limit orders.

Alternative Explanations

Alternative explanations do not make much sense.

First, the negotiation hypothesis of Harris (1991) suggests that the use of coarse price increments to minimize negotiation costs may explain the price clustering of NYSE/AMEX stocks.

Since most small trades on NASDAQ are executed automatically, while large trades are negotiated, this hypothesis predicts that a smaller percentage of large than small trades should be transacted on odd eighths.

Among the NASDAQ stocks, where odd-eighth quotes are rare, negotiated trades in excess of 1,000 shares are far more likely to be transacted on the odd eighths than trades of 1,000 shares or less.

Alternative Explanations

They also provide evidence that the lack of odd eighths is unrelated to trading activity, equity value, and the number of market makers.

While prices and return volatility have some ability to predict the firms that are quoted in odd eighths, the greatest predictive power lies in the historical use of odd eighths.

Thus, their results suggest that the important factor in predicting the use of odd-eighth quotes is not the economic costs and risks of market making, but whether a practice of avoiding odd-eighth quotes is already established.

Conjecture

The quote-setting behavior that emerges when individual market makers implicitly agree to maintain spreads of at least $0.25 by not posting quotes on odd eighths.

Their analysis raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.

Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?By Christie, Harris, and Schultz (1994, JF)

On May 26 and 27, 1994 several national newspapers reported the findings of Christie and Schultz (1994) .

On May 27, dealers in Amgen, Cisco System, and Microsoft sharply increased their use of odd-eighth quotes, and mean inside and effective spreads fell nearly 50%.

This pattern was repeated for Apple Computer the following trading day.

Implications

The fundamental premise of the NASDAQ system is that market makers compete for order flow through prices, and this competition for order flow produces the best order execution for investors.

However, it is difficult to reconcile this competitive model with the finding that trading costs decline by almost 50% in the absence of any apparent change in the costs of market making.

Further, the continued participation of dealers in markets after this decline in their revenues contradicts the premise that spreads were determined through competition before May 27, 1994.

Finally, it is especially difficult to understand why, in a competitive market, over 40 dealers simultaneously changed a pricing practice that had been in effect for years only after the practice was made public.

FX Spreads and Dealer Competition across the 24-hour Trading DayBy Huang and Masulis, ROFS 1999

The foreign exchange (FX) market has a unique combination of features:

– Open 24 hours a day, 7 days a week;– Dealer competition and trading activity vary greatly over a calendar day, as

the level of business activity in different geographic regions ebb and flow;– Has a decentralized multidealer structure;– FX dealers in major currencies have access to well-developed interdealer

market.

These features make studying the effect of dealer competition across regions on the bid-ask spread attractive.

Essentially, we could have a pattern of time-varying and region-varying bid-ask spreads.

Research Design

Spot deutschmark/dollar (DM/$) tick-by-tick quotes of FX dealers, 10/1/92-9/29/93.

The level of competition is measured by the number of dealers active in the market.

Fluctuations in geographically concentrated customer order flow over different portions of the day result in systematic differences in dealer activity levels and quote volatility.

Differential Access to Information on the State of the Market

Dealers’ major sources of information about the current state of the market:– Their broker boxes, which announce the volume and prices of anonymous interdealer

transactions;– Dealers’ direct contacts with their own customers.

Small banks see little of the aggregate order flow in the FX market, while large banks observe a much greater portion of this order flow.

Due to their information advantages, large banks tend to quote more aggressively than small banks.

More aggressive pricing of liquidity services can be expected when a significant number of large banks is in the market.

The makeup of the active dealers matters.

Dealer Activity and Inventory Costs

A dealer’s ability to lay off unwanted inventory is positively related to expected market depth.

An increase in customer order flow and the number of active dealers in nearby future periods should reduce a dealer’s expected inventory costs.

An increase in dealer activity is thus expected to lower individual dealer bid-ask spreads, by increasing competition and market depth.

Volatility and Inventory Risk

Since the value of a dealer’s inventory is directly dependent on the FX rate, a rise in FX volatility causes a rise in dealer inventory risk as well.

In this situation, dealers have incentives to raise spreads so as to lesson the probability of experiencing large unanticipated inventory accumulation and to compensate for bearing more inventory risk.

In sum, there are theoretical reasons why the number of active dealers, their identity, and price volatility should impact bid-ask spread.

Main Result

The expected level of competition, as measured by the number of dealers active in the market, is time-vary, highly predictable, and displays a strong seasonal component that in part is induced by geographic concentration of business activity over the 24-hour trading day.

The expected addition of one more competing dealer lowers the average quoted spread by 1.7%.

Future research??

Investor Protection and Firm Liquidityby Brockman and Chung, JF

This paper posits that less protective environments lead to wider bid-ask spreads and thinner depths

– because they fail to minimize information asymmetries.

The Hong Kong equity market provides a unique opportunity to compare liquidity costs across distinct investor protection environments

– but still within a common trading mechanism and currency.

The SEHK

It lists companies from very different investor protection environments.

Blue chips– generally originate and operate in a favorable investor protection environment.

H shares– shares of mainland companies incorporated in China (former state-run monopolies)

and later granted permission to raise capital in Hong Kong.– Although traded under the SEHK’s rules and regulations, they operate in the Chinese

investor protection environment.

Red chips– Holding componies usually set up by Chinese ministries or provincial governments.– These firms often go public on the SEHK through a “back-door listing,” whereby the

mainland enterprise acquires a small, listed Hong Kong company and then injects it with a combination of mainland- and Hong Kong-acquired assets.

The Sample

33 blue chips– The Hang Seng Index

32 red chips– Hang Seng China-Affiliated Corporations Index

34 H-shares– Hang Seng China-Enterprises Index

Empirical Findings

Firm liquidity is significantly affected by investor protection.

Hong Kong-based equities exhibit narrower spreads and thicker depths than their China-based counterparts.

Implications

Studies have suggested a chain of causation from investor protection to financial development, and from financial development to economic growth.

– Although intuitively appealing, the underlying mechnisms that bind one link to the next remain largely undocumented.

This study establishes one of the connections from investor protection to financial market development.

La Porta, Lopez-de-Silanes, Shleifer, and Vishny (Law and finance, JPE, 1998) state that,

– “The ultimate question, of course, is whether countries with poor investor protections—either laws or their enforcement—actually do suffer.”

The results of this study show that one type of “suffering” comes in the form of higher liquidity costs.

Future research??

Competition, Market Structure, and Bid-Ask Spreads in Stock Option Marketsby Mayhew, JF, 2002

A need to understand the relationship between competition, market structure, and market quality,– liberalization and globalization of capital markets, – information technology, – alternative lower-cost trading mechanism, and– the expansion of derivatives markets.

U.S. Options Markets

The options market in U.S. is a natural laboratory of studying the relationship.

The reasons:– Stock options were first allowed for a single exchange

listing, then multiple listing was allowed and co-existed with the single listing, and eventually all stocks were made eligible for multiple listing.

– Options trade under both open outcry (CBOE) and specialist mechanism (AMEX and PHLX).

– The International Securities Exchange, a new, purely electronic option exchange, was introduced in U.S.

Open Outcry vs. Specialist System

The CBOE was established with an open-outcry “trading crowd” structure, modeled after the trading mechanism used in futures pits.

In 1985, after several OTC options were multiple-listed on the CBOE and AMEX, most of trading volume on these contracts went to AMEX, which uses a specialist system.

In response, CBOE listed some options under a “Designated Primary Marketmaker” (DPM) similar to the specialist system used at AMEX, allowing the open-outcry and specialist structures co-exist within a single exchange.

The structural and regulatory changes in the U.S. provide a rich historical database for studying the impact of competition and market structure on market quality.

Research Design

To examine the effect of competition on spreads, the author compares quotes and effective spreads for multiple-listed and single-listed options,

– where the two options have a similar price and trading volume, and the two underlying stocks have the same volatility.

To examine the effect of market structure, he compares options traded under the open outcry structure with those trading under a Designated Primary Maketmaker.

Findings

Multiple-listed options have narrower quoted and effective spreads than single-listed options.

– The difference in effective spreads seem to be less than the differences in quoted spreads, suggesting that there may be more price improvement for single-listed options.

– The difference diminishes as trading volume increases.

Spreads become wider when an option is delisted by a competing exchange, providing additional evidence that multiple listing matters.

Findings (continued)

Options traded under a DPM have a narrower spreads than under open outcry;– this result is robust only for quoted spreads, not

effective spreads.– Effective spreads are narrower for DPM stocks;

but the opposite result holds prior to 1991.– Also, effective spreads are wider under a DPM for

high-volume options.

Implications

Interexchange competition matter in improving liquidity of options.

On average, effective spreads are three cents narrower for multiple-listed options. But, the difference decreases as trading volume increases.

The DPM appears to perform slightly better for lower-volume options.

The traditional crowd appears to be better for high-volume options.

Future research??

Trading and Pricing in Upstairs and Downstairs Stock Marketsby Booth, Lin, Martikainen, and Tse (2002, ROFS)

An upstairs market is an off-exchange market where buyers and sellers negotiate in the “upstairs” trading rooms of brokerage firms.

The downstairs market is the exchange floor or its electronic counterpart. The trades take place anonymously.

Would the pricing and the trading mechanism be different in these two market structures?

Theories

Seppi (1990) argues that uninformed traders are more likely to go upstairs for direct negotiation, implying that upstairs trades would have lower adverse information costs than downstairs trades.

Grossman (1992) suggests that upstairs brokers can give better prices to their customers if they know the unexpressed demands of other customers (i.e., information repositories).

Hypotheses

Upstairs trades have a less permanent price effect (a change in the equilibrium price level due to information reveled from a trade).

Upstairs trades have a higher temporary price effect, in part reflecting the costs of searching counterparties to complete a trade.

Upstairs trades have a lower total price effect, because of the benefits of direct negotiation and information repositories.

Findings

Upstairs trades tend to have lower information content and lower price impacts than downstairs trades.

The economic benefits of a upstairs market depends on price discovery occurring in the downstairs market.

Future research???

Does an electronic stock exchange need an upstairs market?By Bessembinder and Venkataraman, 2001, JFE

Despite the efficiency of electronic limit order book (downstairs market), virtually every stock market is accopmanied by a parallel upstairs market,– Where large traders employ the services of

brokerage firms to locate counterparties and negotiate trade term.

Why??

Issues Large Traders Face

Two issues are of particular importance to large traders—order exposure and trades’ information content.

Prices are likely to move adversely if the existence of a large unexecuted order becomes widely known,

– other traders may front run the order – or simply infer information about future price movements from its

presence.

A large order, in particular, provides free trading options and risks being picked off if market conditions change.

Possible Benefits of an Upstairs Market

Grossman (1992) argues that upstairs brokers may serve as a repository of information on large investors’ unexpressed trading interests.

– An upstairs broker who receives a large customer order can tap the pool of unexpressed trading interest, while minimizing the degree to which the customer’s order is exposed.

Seppi (1990) argues that upstairs brokers can screen informed traders from the upstairs market,

– lowering adverse selection costs for large liquidity traders.

Hypotheses

H1: Total execution costs for those trades routed to the upstairs market are lower than for similar trades completed in the downstairs market.

H2: Total execution costs for upstairs trades are lower in part because upstairs brokers can tap into unexpressed liquidity.

H3:Upstairs markets are used primarily by those traders who can certify that their trades are uninformed.

H4: Upstairs trades incur higher fixed execution costs to compensate brokers for search and negotiation expenses.

Research Design

Compare actual execution costs in the upstairs market with costs that would have been incurred if the same trade had been routed to the downstairs limit order book.

Examine the factors that govern when upstairs trades are executed at a price outside the quotes in the downstairs market, and study the quality of these executions.

Investigate the popular view that an automated execution system is inherently less expenses than a trading mechanism with human intermediation.

Findings

The upstairs market at the Paris Bourse is an important source of liquidity for large transactions, as almost 67% of the block trading volume is facilitated upstairs.

The option to complete upstairs trades at prices outside the quotes is exercised for large trades, when the downstairs spread is unusually narrow and when there is relatively little depth in the limit order book.

– This suggests that the option of outside the quotes allow some trades to be completed that otherwise would not.

Findings (continued)

Overall trading costs for those block trades completed upstairs are lower than for block trades complete downstairs

– Consistent with the Seppi (1990) prediction that upstairs trades contain less information than downstairs trades.

Traders strategically choose across the upstairs and downstairs markets to minimize expected execution costs.

Findings (continued)

A random selected order would incur higher execution costs in the upstairs market than in the downstairs market. However, due to traders’ efficient selection, average execution costs for large trades routed upstairs are smaller than for trades routed downstairs.

On average, trades are executed upstairs at a cost only 35% as large as if they had been executed against the limit order book in the downstairs market.

– Strong support the Grossman (1992) prediction that upstairs brokers are able to tap into unexpressed liquidity.

Future research??

The Informational Role of Stock and Option Volume

By Chan, Chung, and Fong, 2002, ROFS

Would informed investors prefer to trade options or stocks?

Reasons for options:– Lower transaction cost and greater financial leverage;– Private information on volatility can only be used in the

option market; Reason not for options:

– Lower liquidity

How informative are option trades? Which market does play a greater role in discovering information?

Purpose and Research Design

Provide evidence on the price discovery roles of the stock and option markets.

Examine the information respectively contained in the quote revisions and trades in each market.

– Whether trades and quote returns in each of the two markets have any predictive ability for subsequent trades and quote returns in both markets.

Contribution

Expand the empirical literature on the informational linkage between the option and stock markets by integrating quote return and trades into analysis.

– Informed traders could submit either market orders or limit orders for trading on their private information.

– If they submit market orders, trades will contain information; if they instead submit limit order, their information will be incorporated into quote revisions.

– Either trades or quote revisions can be informative.

Findings

Stock net trading volume (buyer-initiated volume minus seller-initiated volume) has strong predictive ability for contemporaneous and subsequent stock and option quote revisions, but option net trading volume has no incremental predictive ability.

– suggesting that informed investors initiate trades in the stock market only.

Option quote revisions, as well as stock quote revisions, have predictive ability for subsequent quote revisions in the other market.

– implying that while information in the stock market is contained in both quote revisions and trades, information in the option market is contained only in quote revisions.

Discussion

The evidence that option quote revisions, not option trades, contain information is particularly interesting, yet a little puzzling.

Even though informed investors may also trade in the option market, they do not initiate trades aggressively.

– they submit limit orders, instead of market orders.

Given the benefit of greater financial leverage associated with the options, it might be surprising that informed investors still hesitate to initiate option trades.

– One possible reason is the low liquidity in the option market.– Perhaps the benefit of immediacy has to be large enough to

induce informed traders to initiate trades in the option market.