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8/2/2019 Biais 1 Market Org

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The Organization of Financial

Markets

Bruno Biais

Toulouse School of Economics

Rotman Schools Distinguished lecture SeriesToronto University

January 2008


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G oal

Describe the way orders are matched & prices areformed in major financial markets.Understand mechanics of market process.Be aware of the variety of trading systems acrosscountries & markets.Knowledge necessary for theoretical analysis(extensive form of the game) and empiricalstudies (where does data come from?)


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Outline1) Order driven markets: Limit Orders,Market orders, Call Auction, ContinuousMarket.2) Dealer markets3) Mixed market structures


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Order driven & quote driven marketsOrder drivenmarkets

Mixed/hybrid marketstructures

Quote drivenmarkets

All investors canannounce prices

at which theywant to buy or sell (via brokers)

As in order driven +specialist or market

makers

Onlyspecialist/

marketmakers/dealers postquotes

Euronext, Tokyo,Inet, Hong Kong,Toronto Stock Exchange

Frankfurt, London, NYSE, Nasdaq, Matif,Xetra, Eurex (seewww.eurexchange.com)

London & Nasdaq before 1997,FX, Bonds,

Derivatives


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1) Order driven markets


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Limit orders and market ordersLimit buy order : I want to buy 100 sharesat price no larger than $ 60 per share.Market buy order: I want to buy 100 sharesat any price.Limit sell order: I want to sell 100 shares at$ 80 per share or above.Market buy order: I want to buy 100 shares,at any price.


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The limit order book The limit orders which have been placed,and have not yet been executed, cancelledor revised are collected in the limit order

book.


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A day at the exchange

Opening(9:00 CET)

Close(5:00 CET)

Continuous marketPreopening After hours


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Call auctionUsed to set the price at the opening of the market(NYSE, London Stock Exchange, Paris Bourse,

Frankfurt, Madrid, Milan,Eurex)All buy orders cumulated: demand functionAll sell orders cumulated: supply function

Price set to maximize trading volume.All buy orders at or above this price filledAll sell orders at or below this price filled


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The limit order book at the opening of the marke t

Price i t sel l or Supply Limit buy orders Demand Volume50 10 10 0 170 1060 10 20 0 170 2070 0 20 0 170 2080 5 25 0 170 2590 0 25 0 170 25

100 10 35 10 170 35110 10 45 0 160 45120 0 45 0 160 45130 0 45 0 160 45140 0 45 0 160 45150 5 50 10 160 50160 10 60 10 150 60170 5 65 10 140 65180 10 75 0 130 75190 0 75 5 130 75200 0 75 5 125 75210 0 75 5 120 75220 0 75 0 115 75230 10 85 0 115 85240 10 95 5 115 95250 5 100 5 110 100260 10 110 10 105 105270 5 115 10 95 95280 5 120 0 85 85290 0 120 0 85 85300 5 125 0 85 85310 5 130 5 85 85

320 5 135 5 80 80330 10 145 5 75 75340 10 155 0 70 70350 5 160 0 70 70360 5 165 10 70 70370 5 170 10 60 60380 0 170 10 50 50390 0 170 10 40 40400 0 170 10 30 30410 0 170 10 20 20420 0 170 0 10 10

430 0 170 0 10 10440 0 170 5 10 10450 0 170 5 5 5

Cumulatedsupply

Limit ordersto sell

Cumulateddemand

How muchcan be tradedat that price =

Min[Supply,Demand]

Limit orders to buy


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Supply and demand at the opening call auction

020406080

100

120140160180

0 50 100 150 200 250 300 350 400 450 500

Price

Q u a n t i t y

SupplyDemand

Volume maximizing

price: 260


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RationingBecause we are working with stepfunctions/discrete pricing grid, at the volume

maximizing price supply is not always equal todemand.If that happens rationing on the sell or the buyside. (In our example 5 sales offered at 260remained unexecuted).Time priority usually applies (First In First Out).


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Uniform price

In this auction all trades are conducted atthe same (uniform) price.

Limit buy orders at price 355 are filled atthe equilibrium price: 260Limit sell orders at price 150 filled at 260

If many traders, each has little impact on price: price at which limit order is placedmainly influences its execution probability(not the price at which it is filled).


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Preopening ttonnementNot easy to find the opening price (news,overnight order flow, how to react to Tokyo sclose, etc)To help traders figure out this, exchanges(Xetra, Toronto, Euronext, Madrid, ) allowfor order placement an hour before opening.

Indicative preopening prices computed astraders place, revise, cancel orders (no trade atthese prices).


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Does preopening period help?

Could help coordinate expectations, advertiseliquidity demand.

But since orders can be withdrawn, they could be purely manipulative. Then preopeningindicative prices would be pure noise.Biais, Hillion, Spatt ( Journal of Political

Economy , 1999): empirical study of preopening period in Paris Bourse. Preopening indicative prices do convey useful information, especially

in the last 10 minutes..


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After the opening

Executed buy and sell orders are no longer in the book. Unexecuted buy orders (placedat price below the opening price) and sellorders (placed above the clearing price)remain in the book.Best offer to sell: ask price, best bid to buy:

bid price. Difference: bid-ask spread.Quantity offered at the ask: depth at the ask,quantity at the bid: depth at bid.


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The order book just after the opening of the market

Price it sell or Supply Limit buy order Demand50 0 0 0 6560 0 0 0 6570 0 0 0 6580 0 0 0 65

90 0 0 0 65100 0 0 10 65110 0 0 0 55120 0 0 0 55130 0 0 0 55140 0 0 0 55150 0 0 10 55160 0 0 10 45170 0 0 10 35180 0 0 0 25190 0 0 5 25200 0 0 5 20210 0 0 5 15220 0 0 0 10230 0 0 0 10240 0 0 5 10250 0 0 5 5260 5 5 0 0270 5 10 0 0280 5 15 0 0290 0 15 0 0300 5 20 0 0310 5 25 0 0320 5 30 0 0330 10 40 0 0340 10 50 0 0350 5 55 0 0360 5 60 0 0370 5 65 0 0380 0 65 0 0390 0 65 0 0400 0 65 0 0410 0 65 0 0420 0 65 0 0430 0 65 0 0440 0 65 0 0450 0 65 0 0

All the limitsell orders

placedabove 260

are filledAll limit

buy orders placed at or

above 260are filled


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The order book just after the opening call

0

10

20

30

40

50

60

70

0 50 100 150 200 250 300 350 400 450 500

Price

Q u a n t i t y

Supply

Demand

Best bid: 250 Best ask: 260

Depth at

Best ask:5 shares

Depth

at best bid: 5shares


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V isibility of order book

In Xetra, Euronext, or Inet several orders oneach side of the book are visible on traders screens. Orders further away from the quotes are

not visible. [If you want to see live order book go to http://data.inetats.com/ds/tools/charts greatstuff]Until 2002, on the NYSE only the specialist sawthe orders in the book. Since 2002: NYSE open

book. Traders off the floor can electronicallyobserve the order book.


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Inet Order Book, Dell, April 19 2006


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The continuous market

Investors can place new market or limit orders inthe book or cancel limit orders that have not

been filled or trade against limit orders present in

the book.If more than one order are present at a given

price time priority applies.Opening: multilateral trading, many investors

participate in opening trade.Continuous market: bilateral, match one buyer and one seller.


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Example9:00: 5 shares are offered at the best ask (260), 5 more at

270.and 5 shares are demanded at the best bid (250).9:05: market order to buy 2 shares; immediately filled at

price 260. Bid-ask spread remains the same but depth atthe ask reduced.9:06: limit order to buy 10 shares at 255, spread reducedto (260-255).9:10: Market order to buy 5 shares.

p

t

260

250

9:00 9:05 9:06

Ask

Bid255

T


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Order flow dynamics

Biais, Hillion & Spatt, Journal of Finance , 1994.After large purchases ask & bid quotes shifted upward.When spread large, limit orders within quotes frequent. When depth at quotes limited, limit orders at quotes

frequent. When spreads tight & depth large, market orders

frequent.

Order types positively serially autocorrelated: Large orders follow large orders. Buy orders follow buy orders.

Market orders follow market orders.


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Order dynamics in Toronto Stock Exchange

G riffiths , Smith, Turnbull & White, Journal of Financial Economics , 2000.

Aggressive buy (sell) orders tend to follow other aggressive buy (sell) ordersThey occur when bidask spreads are narrow and

depth on the same (opposite) side of the limit book is large (small).Aggressive buys are more likely than sells to bemotivated by information.


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Technology

Until 80s, most stock and futures markets based onfloors, while Nasdaq, the London Stock Exchange,and bond, OTC & currency markets telephone

based.

Since 80s, trend towards electronic computer basedtrading platforms: Euronext, Eurex, Xetra, LSE, Nasdaq, Toronto.Lower processing costs, greater ability todisseminate info & connect to the market, level

playing field/less adverse selection.But NYSE & US futures markets still to some

extent floor based (unlike Europ stocks & futures).


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Best execution and price priorityPrice priority: If someone offered to sell at 260(for example by placing an order in the book) then

broker receiving an order to buy cannot execute it

at a higher price : Broker must seek bestexecution.Priority rules easier to enforce if transparentmarkets & information widely disseminated; eveneasier if centralized computerized order book.Why price priority? To prevent brokers fromripping off customers, to incentivize investors to

place bids in line with their valuation of the asset.


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Liquidity demand and supply

Traders placing market orders demandimmediacy, they want rapid execution: theydemand liquidity

Traders placing limit orders stand ready to tradewith incoming market orders: they supplyliquidity.Intermediaries acting as market makers by

placing limit orders: earn spreads.Investors willing to delay execution to lower cost of trading: avoid paying spreads.


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2) Dealer markets


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Quote driven marketsDealer markets are quote driven: only certain

players (have the right to) post bid and ask quotes and thus supply liquidity: Forex market,

OTC, US futures markets, These players arecalled market makers or dealersObligations: to post quotes, limit on spread,minimum on quantity, reporting requirements.Privileges: right to post quotes, informationabout order flow and book, lower or no fees paidto the exchange.


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Dealers revenues and costsRevenues: Dealers try to buy low (bid) & sell high

price (ask). Earn bid-ask spread.Costs: Between purchase & sale, hold security in

inventory: Risk bearing cost/inventory cost. If, market buy followed by price increase, loss for

dealer. Arises if market orders placed by informed

agents. Adverse selection cost.Competitive dealers: Bid-ask spread = compensationfor inventory costs & adverse selection costs.Market power: spreads also reflect rents


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Why could dealership make sense ?

1) Fixed cost to provide liquidity: link withelectronic system, stay on floor; acquireinformation.Efficient to spread this cost over many trades.Thats what professional market participants(dealers & market makers) do. Thus, the finalinvestors participating infrequently to the market

do not incur this fixed cost.2) It takes initial liquidity to attract orders(priming the pump) & dealers can help

coordinating expectations about liquidity.


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Potential drawbacks

If only small group of market participantsallowed to supply liquidity, risk of collusion.Tents at expense of outsiders.Nasdaq before 1997. Christie and Schultz( Journal of Finance , 1994): Nasdaq dealerstraded only even eighths. After CSs article &Wall Street Journal sudddenly use odd eighths.

SEC Order Handling rule (1997): Limit ordersmust be displayed + internet technology: ECNrun electronic limit order book. Investorscompete to supply liquidity: Spreads narrow.


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An important dealer market: the Forex market

Customer Customer

Bank

Bank

Bank

Today/yesterday (EBS):Observe quotes

Post quotes

Customer Customer

Bank

Bank

Bank

Tomorrow? (FXAll. Online FX only about 1% of total):Observe quotes

Post quotes


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Interdealer tradingWhen one customer trades only with one dealer,the latter rebalances its trades with other dealers.When customers can spread their trades between

several dealers, less need to rebalance trades.Empirical prediction: as forex market switchesto internet trading systems, trades between

customers and dealers will grow relative tointerdealer trading.


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Comparing order driven & quote driven

Customer Customer

Dealer

Dealer

Dealer

Observe quotes

Post quotes

Forex tomorrow or LSE yesterday:

Customer

Customer

Dealer Dealer

Observe quotes

Post quotes

LSE today:


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3) Mixed market structures


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Mixed market structureInvestors placing limit orders along with

professional market makers stand ready toserve orders to buy or sell & provideimmediacy.NYSE: as in order driven marketsinvestors can enter limit orders in the

book; in addition specialists manages the

book, can enter his/her own orders. Mustmaintain an orderly market.


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NYSE

Investor

Investor

Investor

Investor

Electronic Limit

Order Book

Electronicorder submission

Electronicorder submission

Specialist

Broker Broker

Manual order

Face tofaceinteraction


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Who Trades on the NYSE?(Source Moulton, 2006)

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

70,00%

80,00%

Who trades

SpecialistFloor brokerSystem

Most orders and trades are electronic.For small stocks specialist intervenes more, brokers less.


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Who Trades with Whom on the NYSE?(Source Moulton, 2006)

0,00%5,00%

10,00%15,00%20,00%25,00%30,00%

35,00%40,00%45,00%50,00%

Who trades with whom?

Pure floorFloor & systemPure system

Most trades involve electronic orders on one or both sides.Percentage pretty stable across stocks.


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Advantages of this dual system

Investors can place limit orders, and thuscompete to supply liquidity, especially since2002, NYSE open book.

Specialist constantly monitors market, intervenesto supply liquidity if transient mismatch(intertemporal intermediation.)

Long term relationship between brokers andspecialists: reputation effects can mitigateadverse selection problems.


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Drawbacks

Until 2006, direct access to electronic system(NYSE Direct +) limited: Order size < 1099shares. Not more than one order per 30 seconds.

NYSE rules allow brokers on the floor to violatetime priority of orders in the book, stepping in

before order is hit.

Competition between floor and electronic book biased: adverse selection problem for floor.


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Hybrid market

Approved by SEC March 2006. Lift restrictionon Direct + orders: 1099 shares and 30 secs.Investors who want direct and immediate

execution against the order book can request it:NX. NX orders can sweep the book.Investors who prefer to allow specialist or broker to step in can request it.These new rules make NYSE more similar toEuropean electronic limit order books, whilekeeping some of the advantages & drawbacks.


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Brokers in hybrid market

Brokers can electronically place limit orders inthe book: e-quotes.Brokers can choose to hide these orders or make

them visible (// Euronext or Inet.)Only brokers can hide orders (way to preservesome of the franchise of brokers.)

Specialist can see aggregate amount of hiddenorders but not details (way to preservespecialists franchise.)


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LRPs in hybrid market

Liquidity replenishment points.When large price change: If individual order moves stock price by > 9 cents. Or if stock

price moves by > 25 cents or 1% price in 30secs.Maybe due to transient lack of liquidity.

Automatic execution halted. Specialist triesto elicit liquidity supply. Automatic marketstarts again after manual trade or 10 secs.


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LRP Tradeoffs

Pros: LRP maybe triggered by transient lack of liquidity: lots of relatively uninformed buyorders, liquidity demand exceeding depth in the

book, optimal to advertise this imbalance & call

for liquidity supply.Cons: Automatic execution halted, specialist andfloor brokers find out if sudden flow of marketorder was uninformed. If it was, provideliquidity. Otherwise execute against book.Adverse selection problem for book.Solution: Run electronic auction with equal

access to floor & electronic traders?


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ConclusionTrend in equity markets (and also other marketssuch as government bonds or forex): Electroniclimit order books. NYSE was able to resist thistrend for a long time because of its quasi

monopoly position. European Exchanges, whichcompeted against one another had to moveearlier.

Trend much less clear in other markets,especially bond market. There OTC dealership prevails. Why? Is this going to last? What arethe consequences?

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