Financial Market Microstructure

1
Financial Market Microstructure

• In this section we examine financial
• markets in detail. Financial Markets
• Where financial assets are traded.
• Why is it important to examine markets?
• Because the characteristics of markets
• can affect
• trading costs
• the speed with which information is reflected
  in prices,
• and the accuracy of prices in reflecting
  available information.
• 4 issues to consider
• types of markets
• types of orders
• types of traders
• the trading process

2
Types of Markets

• Primary or Secondary Market
• Primary security markets where new issues of
  securities are initially sold. E.g. SARB
  auctioning new treasury bills.
• Secondary A market where securities are resold.
  E.g. the JSE.
• Call or Continuous Market
• Call markets where trading takes place at
  specified time intervals. These can be verbal
  based or computer based.
• Continuous market markets where
• trading takes place continuously.

3
Types of Markets

• Dealer or Broker Market
• Broker (pure auction market) Broker buys
• and sells shares on the investors behalf.
• Shareholders are trading with other
• shareholders using an agent. Market found
• at a particular location, such as the trading
• floor of a stock exchange.
• Dealer Investors trade with the dealer, not
• with other investors. The dealer has to hold
• inventory of shares. These markets are
• often physically dispersed and trading done
• by phone and computer.
• Improvements in technology have lessened
• the distinctions between broker and dealer
• markets.

4
Desirable Characteristics of Markets

• Buying and Selling Done Based on
• Available Information
• Useful information includes past prices, volume,
  current bids and offers.
• Low Trading Costs
• Liquidity
• Ability to transact a large number of shares at
  prices that dont change substantially from past
  prices unless there is new information.
• New Information quickly incorporated into
• prices.
• Efficient market hypothesis.

5
Types of Orders

• Market Orders Most common type of order
• placed by an investor on the JSE. It is an
• order to buy or sell at the best price
• currently available.
• Limit Orders This is an order to buy/sell
• at a maximum/minimum price. These orders
• control the price paid or received, but
• investor has no way of knowing when the
• order will be filled.
• Short Sale Investor sells securities she
• doesnt own. Investors do this when they
• expect to make a profit from a decline in the
• share price.

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Types of Traders

• Active versus Passive
• Active traders normally use market orders.
• They demand immediacy and push prices in
• the direction of their trading.
• Passive normally use limit orders. Tend to
• stabilize prices. Dealers are typically
• passive traders. Passive traders tend to
• earn profits from active traders.
• Individual versus Institutional
• Institutional Pension funds, mutual funds,
• foundations tend to be the biggest players in
• stock and bond markets. Trade in large
• quantities.
• Individual Trade in small amounts but
• account for the bulk of trades.

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Types of Traders

• Liquidity versus Informed
• Liquidity Trade to smooth consumption or
• to adjust the risk-return profile of their
• portfolios. They buy stocks if they have
• excess cash or have become more risk
• tolerant. They sell if they need cash or have
• become less risk tolerant. These traders
• tend to trade portfolios.
• Informed Trade on private information
• about an assets value. Believe price is
• incorrect and buy/sell based on perceived
• mispricing. These traders tend to trade in
• the specific asset for which they have
• private information.

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The Trading Process

• The elements of the trading process can be
• divided into 4 components
• Information
• Order routing
• Execution
• Clearing

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The Trading Process

• Information
• Markets provide information about past
• prices and current quotes.
• Modern stock exchanges will provide
• transaction prices and quotes in real time
• using a consolidated trade system (CTS)
• and a consolidated quote system (CQS).
• Real time dissemination of information
• makes markets transparent and allows
• investors to determine which markets have
• best prices, which enhances competition.

10
The Trading Process

• Order Routing
• Brokers take orders and route them to an
• exchange or other market centre.
• Retail brokers establish procedures for
• routing orders and may route orders in
• return for payments.
• Orders may not enjoy the benefit of being
• routed to every trading centre. This means
• orders will not obtain the best possible
• price.

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The Trading Process

• Execution
• The process of matching an incoming
• market order with an existing quote.
• Dealers may delay execution to ensure that
• they have all available information about a
• particular stock.
• Clearing and Settlement
• Involves the comparison of transactions
• between buying and selling brokers.
• In modern markets these comparisons are
• made daily.
• This is done by specialised firms.

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The Trading Process

• Trading Costs. 4 major sources
• Directs costs, commission to
• brokers, plus a tax on the trade.
• The bid-ask spread The difference between
• what the investor buys the asset for and
• what she then sells it for.
• Impact of large sales and purchases These
• may have an adverse effect on the bid and
• ask.
• Deviations from equilibrium prices
• Information can take long to be incorporated
• into share prices.

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The Trading Process

• Determinants of the bid-ask spread
• Order handling costs costs of labour and
• capital needed to quote information, order
• routing, execution and clearing.
• Non-competitive pricing market makers
• may have agreements or adopt rules to
• increase spreads.
• Inventory risk The risk associated with a
• change in price while holding a particular
• stock. E.g. dealer buys 10000 shares at the
• bid price risks a drop in the price.
• Asymmetric Information Investors who are
• better informed gain at the expense of less
• informed investors.

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Herding

• Herding arises when investors decide to imitate
  the observed decisions of others in the market
  rather than follow their own beliefs and
  information.
• What is the price effect of aggregate selling or
  buying by several institutions? This type of
  behaviour can lead to a price imbalance.
• Institutions herd because they tend to listen
  to the same analysts.
• Mutual fund buying is more likely when past
  returns are positive, has a strong positive price
  effect, and is followed by future positive
  returns.

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Price imbalance from trade data

• St number of shares traded below the quoted
  midpoint
• Bt number of shares traded above quoted
  midpoint
• The proportional imbalance for the day is
• It Bt St/ Bt St
• Estimate following regression
• ?Pt ?0 ?1 It ?2 It -1 et
• where ?Pt change in stocks
• midpoint quoted value
• ? sensitivity of the quote change to
• the imbalance.

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Price imbalance from trade data

• Stoll (2000) estimates the above regression for
  1706 NYSE stocks.
• The value of ? is positive and highly
  significant. This indicates that trading pressure
  affects prices.
• Implication Possible that stock prices will not
  reflect fundamentals, but sentiment. Especially
  when there is asymmetric information.
• Evidence suggests that investors over-react to
  bad news.

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Some Issues in market design

• The way the market is designed will affect
• what type of traders participate, the overall
• trading process and the behaviour of prices.
• 3 factors to consider
• Transparency
• Anonymity
• Automation

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Some Issues in market design

• Transparency Refers to the disclosure of
• quotes (at which trades can take place) and
• of transaction prices (at which trades did
• take place).
• Benefits of transparency
• Speeds price discovery and enhances market
  efficiency.
• Helps customers monitor brokers customers can
  check whether his transaction agrees with other
  transactions.
• Enhances competition.

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Some Issues in market design

• Anonymity Should the identity of
• traders be revealed?
• Some traders e.g. dealers want to be known
  because they want to build reputation.
• Other traders e.g. pension funds want to remain
  anonymous. Disclosure of their identity may cause
  prices to move against them.
• If institutional investors are unable to
  capitalize on their special information, the
  incentive to research is reduced. This hinders
  information production.

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Some Issues in market design

• Automation
• Increases the speed at which
• transactions can take place.
• Widens the time frame during which
• trade occurs.
• Expands the parameters of the market.
• A fully automated system is more successful for
  orders that do not require
• negotiation (small orders).
• Large orders, where negotiation is common are not
  automated.