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Topic 7. Intermediated Markets. The Plain Vanilla Order Drive Market. We have thus far considered The plain vanilla, order driven market A simple limit order book Continuous trading and call auction facilities. Is Trading Really This Simple?.
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Topic 7 Intermediated Markets
The Plain Vanilla Order Drive Market We have thus far considered • The plain vanilla, order driven market • A simple limit order book • Continuous trading and call auction facilities
Electronic Order Book Systems Work Well For • Retail order flow • Liquid stocks • Non-stressful conditions But A Plain VanillaElectronic Trading SystemCannot do it All
The Need for Intermediation • Emergence of the Modern Markets • Intermediation on the New York Stock Exchange • Intermediation at NASDAQ Read on Your OwnText Pages 217 - 238
The Ecology of an Order Driven Market Can Break Down • Free riding • Small and mid-cap stocks • Stressful conditions
Stressful Conditions • A bear market • Advent of news • Derivatives expirations • Momentum trading • Daily openings • Arrival of a 300,000 share order
Market Maker Services • Immediacy • Supplemental liquidity • Price discovery • Animation • Price improvement (pages 258-260)
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 Revenues • Spread • Trading the Order Flow • Commissions
Market Maker Costs • Inventory cost: Cost of carrying unbalanced inventory • Information cost: Cost of trading with better informed participant
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 • Receiving a large percentage of the order flow
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 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 "Shares sold to a market maker are still for sale” You do not want your inventory revealed by a trade publication
How 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
Market Maker Preferencing What effect would preferencing have on • The volume of orders you receive? • Your inventory control? • Your profitability? Under which regime would you prefer to operate: • Preferencing, or • Strict price and time priorities?
The Challenge How do you handle an order to buy half a million shares of a stock that, on average, trades 300,000 shares a day? • Dealer capital • Shop the order • Slice and dice the order and submit the tranches to an electronic platform • Call auction • Block trading facility
Costs • Bid-ask spread • Market impact • Opportunity cost • Implementation short fall • Losses due to bad market timing
Performance Measure Difficult to measure performance • Need a good benchmark • Do not make assessments on a trade-by-trade basis • TraderEx point score
Electronic Intermediaries Dark pools • Crossing network (e.g., Posit, Matchpoint) • Negotiation venue (e.g., Liquidnet) • Order matching system (e.g., Pipeline)
Dark Pools Free Riding On Price Discovery While Offering Quantity Discovery • Institutions keep their orders hidden to control their transaction costs • How do they find each other and trade? • The problem is called Quantity Discovery
Shortcomings of Dark Pools • Lack transparency • Low crossing rates • Exclusivity • Sheer numbers
TraderEx Block Trading Block Board
TraderEx Block Trading • Institutional Orders • Pipeline Order Flow is separated from the Order Book • Price of order execution is determined from the Market (Order Book) • Minimum Order Size Constraints
TraderEx Pipeline Orders and Execution • Passive Order – Bid price is below the bid/ask spread midpoint • Active Order – Bid price is above the midpoint • Vice versa for ask price • Market / Limit • Reward for being Aggressive
TraderEx Pipeline Colors and Features • Orange : There is a pipeline order for that stock • Orange with Red : You have placed a sell order • Orange with Green : You have placed a buy order • Yellow with Green : You have placed an aggressive buy order and there is a passive sell order • Yellow with Red : You have placed an aggressive sell order and there is a passive buy order
TraderEx Pipeline • Take (Hit) the Passive Offer (Bid) • Bid/Ask spread protection Take Bid