Investments and Financial Markets

Transcription

1 Investments and Financial Markets Part I: The stock exchange and the organization of trades UE 106

2 The stock exchange and the organization of trades 1. Structure and regulation (Ch. 1, sections 1 & 4) 2. Activities of an exchange operator (Ch. 1, section 2) (Ch. 2) (Ch. 2) 5. Liquidity (Ch. 3) 6. Exercises 1.Structure and regulation 5. Liquidity 2

3 Order (trading instruction) Market structure «Paris» as of November 2007 DTCC EuroCCP EMCF Post-market, clearing, settlement Euroclear LCH Clearnet Intermediaries, ISP Relit RGV Regulation and monitoring ESMA AMF Determination of trading price Euronext EBA, EIOPA Banque de France E- broker Banks ISP Members MTF: CHI-X, BATS, Turquoise, Tradegate No price discovery Internaliser Crossing, dark pool 1.Structure and regulation 5. Liquidity 3

4 Anatomy of a trade Investor (account) Bank, broker (back office) custody settlement clearing Quote Trading Member Bank, broker (front office) Investor (submits an order) Deutsche Börse Bank, Broker (front office) NYSE Or LSE Investor (submits an order) 1.Structure and regulation 5. Liquidity 4

5 Regulated markets, MTF and SI MiFID, 2007 Regulated markets (RM) Primary and secondary market Regulation by a national authority (AMF in Paris, FCA in London) Traditional markets: NYSE Euronext Paris, LSE But, also new markets Multilateral Trading Facilities (MTF) Transparent (CHI-X, NYSE-ARCA) or opaque/dark pool (SmartPool, CHI-Delta) Including a primary market (AlterNext) or not (majority) Including price discovery (prices determined through the matching of supply and demand) or not (trades occur at a reference price taken from another market, darkpool) Systematic internalisers (SI) Rather confusing? See as of 26 July regulated markets (RM), of which 4 by AMF (FR), 12 by FCA (UK) and 16 by BaFin (GER) 153 MTF, of which 5 by AMF, 73 by FSA and 13 by BaFIN 11 SI, of which 1 by AMF (Sté Générale), 7 by FCA 1.Structure and regulation 5. Liquidity 5

6 European markets European directives ISD (Investment Services Directive): Adopted as Loi MAF in France in 1996 modified in 2007 MAD (Market Abuse Directive): Proposals adopted in October 2011 and amended in July 2012 EMIR (European Market Infrastructure Directive): March 2012 MiFID II: Finalized in 2014 and to be implemented by end of 2015 RM, MTF and SI: The three categories remain OTF (Organized Trading Facility) Mostly on commodity derivatives. No proprietary trading. What is new with MIFID II? More transparency + stricter regulation of algorithmic trading and derivatives Algorithmic trading (Art. 17), obligation for risk control Tick size (Art. 49) will be regulated by ESMA from 2016 onwards Synchronization of time differences (Art. 50), from 2015 onwards Consolidated tape? (Still not implemented in 2014) On a voluntary base Position limits (Art. 57) in certain contracts (commodity derivatives) 1.Structure and regulation OTC (over-the-counter) markets still the least regulated. 5. Liquidity 6

7 Display of market data U.S.: consolidaton of data is a legal obligation Consolidated tape (since 1976): centralized display of transactions (legal obligation) Consolidated quote (since 1978): centralized display of orders Obligatory re-routing of order to the platform with best price quote Europe (MiFID) : private solutions (lots of announcements) Nasdaq OMX and Ultrafeed market data service (since 2013) GL Trade (SunGard Global Trading) Created in In 1992, SBF (predecessor of Euronext) becomes majority shareholder. In 2008 Sungard takes over. Cinnober (ex Markit boat) NYSE technologies announced in 2011? (see Agéfi) 1.Structure and regulation NYSE best quote and trade announced in April 2013? (see tradersmagazine.com) 5. Liquidity 7

8 Activities of an exchange operator 1. Matching of supply and demand (trades, secondary market) 2. Managing the display of orders (trading intentions) 3. Determining trading prices 4. Derivatives trading or not 5. Involved in primary market activities (listing) or not 6. Clearing and settlement integrated or not 7. Sales Market data Technology Licences (indices) Business strategy? Involved in some of the above activities and not in the others? Which customer base? Pricing? 2.Activity segments of an exchange operator 6. Exercises 8

9 ICE-NYSE ICE: derivatives Euronext-Liffe Short-term interest rate derivatives NYSE (New York) NYSE-ARCA (MTF) UTP platform Mahwah (New Jersey) Euronext Paris, Amsterdam, Brussels, Lisbon Clearing in Lisbon Alternext (MTF) SmartPool (Darkpool) UTP platform Basildon (London) 2.Activity segments of an exchange operator 6. Exercises Deutsche Börse EUREX Long-term interest rate derivatives Derivatives on stocks and indices Clearstream Xetra (Frankfurt) BATS/CHI-X Pan European Stock Exchange London SmartPool (Darkpool) CHI-Delta BATS Europe Darkpool 9

10 Competition between trading platforms, segmentation Latency Improve infrastructure Update softwares (faster, more efficient, less controls?) Colocation Low transaction costs Fees: you can get paid for sending orders! Lower frictions (tick size, prices expressed in $1/1000) Liquidity (small spread, high depth) Cutting operational costs (no more open outcry markets) Going further Acquisition of competitors? Collusion? Increased benefits from changes in the regulation (capture of regulators, see Landier & Thesmar, 2010, p. 91- ) Market segmentation (to alleviate competition on prices) 2.Activity segments of an exchange operator 6. Exercises 10

11 Broker (agency) based markets Supply and demand are directly matched Intermediaries (brokers) buys/sells securities on behalf of their clients Opposite of dealer based markets Relies on the existence of a limit-order book The order book can be managed manually Or using a computer program Implies a call-auction One or more Shares can possibly be traded continuously once the callauction has been conducted 11

12 Characteristics of electronic broker markets Lower functioning costs Explicit: fosters competition by removing barriers to entry Speed: SETS (2012) latency time < 6 mili second. Redline Trading of ICE (2013) proposes ultra-low latency < 5.5 micro second. Transparency (potentially) Monitoring markets easier Progressive in nature Relocation is easy Evolve as fast as technological changes (in line with high speed computers, network, fiber and telecom developments) Recently NYSE-Hybrid, generalized as of 2006 CHI-X, Turquoise, Nasdaq OMX Europe Derivatives trading; ICE, ICE Futures End of open outcry markets in CME as of July

13 Order book Standard display (framed) Euronext, March 23, 2011 at 11:22:06 am, Air Liquide Price Quantity Cumulative quantity See Table 2-1 Orders from sellers Orders from buyers 1. Price quotes : Price limits of posted orders Descending order (price priority) These are firm commitments 2.Price grid (here 1 cent) 3.Buyers (demand for stock) Lower part Best buying price? 4.Sellers (supply of stock) Upper part Best selling price? 5.The bid-ask spread Buyers and sellers cannot be matched Bid=91.52, Ask=91.55 Spread = 3c or.033% (quoted spread) 6.What happens if: A buyer for 100 stocks? A seller for 500 stocks? A buyer for 100 stocks at 91.53? 7.Supply and demand curves 13

14 Supply and demand curves Air Liquide on Euronext UTP, March at 11:22:06 Supply (seller) Demand (buyer) 14

15 Supply and demand (standard) Price Supply (sellers in book) Demand (buyers in book) Cumulative quantity 15

16 UTP (continu A) session Trading "at the last price": 5:35 to 5:40 pm Pre-opening 7:15 to 9 am Continuous trading 9 am to 5:30 pm Pre-closing 5:30 pm to 5:35 pm Call-auction Opening call-auction 9:00 am The time at which trades take place is known ahead Closing call-auction 5:35 pm Market opening takes place at 9 am and closing takes place at 5:35 pm 11 am and 4 pm for shares traded using bi-daily call-auctions (fixing a) 9 am opening call-auction: All orders posted in the order book from 7:15 am to 9 am are confronted with each other 5:35 pm closing call-auction: All orders posted in the order book from 5:30 pm to 5:35 pm are confronted with each other All executed orders trade at a single price determined at the call-auction 16

17 Orders market order (au marché): no price indication Pure market order limit order (à cours limité) Maximum price (buy order), minimum price (sell order) Others (see chapter 2, section 2) Market to limit order (formerly best limit or at best) Stop loss (buy) order Pegged order Qualifiers: iceberg, fill or kill, fill and kill Time validity: valid for 1 year; cancellation is possible Short sales Over 60 order types 17

18 Orders and underlying strategies Time dimension Risk Informational implications Market order Investors in search of immediacy. Immdediate execution (provided matching is possible). Triggers a trade The order walks the book if large. Market impact. The trader only sees what happens after her order is executed Liquidity Liquidity demand Liquidity supply Limit order Patient investor. The order can wait for execution for several trading sessions. Control over execution price Non-execution risk The investor reveals information regarding its reservation price. The order incurs the risk of being picked-off by better-informed traders. See chapter 2, section

19 Volatility capture Sell orders Buy orders Price 1. You post buy (d) and sell (3) orders 2. Buyers exhaust limit (1) 3. Then (2), and (b) and (c): high volatility! 4. Your orders get executed (3 and d) Time 19

20 Volatility capture The stock is trading at 100 (on the left axis). You place a buy order at 90 and a sell order at 110. What is the idea behind such a strategy? The thin and bold lines represent 25 simulated price observations with 20% and 120% volatility, respectively. Sell at 110 Sell at 110 Buy at 90 Buy at 90 20

21 Algorithmic and high frequency trading (HFT) What are they? Algotrading: automated execution of an order (Slicing of the order? Optimal routing? Must account for trading prices net of costs as well as expected trading volume) HFT: algo trading + trading decisions (based on information, trading patterns, forecasts about other algorithms' behavior) Is it economically significant? In Europe, Aite Group estimates that 25 % of trading volume is made by algos (Oct. 2010) and 45% in Absence of reliable statistics. In Paris (April, 2010), 3 members (Citadel Securities, Getco et Knight Capital Group) account for 50% of total orders Execution rate: between1 and 5% Chapter 2, section

22 Call auction on UTP (since 2013) Chapter 2, section 1.4 All orders are executed at the same price Price must be consistent with trading instructions embedded in orders Orders whose price limit equals the call-auction price can receive partial execution In case of partial execution, orders are executed according to FIFO Call Auction Algorithm 1. The price is set so as to maximize the number of traded shares (if multiple eligible prices, move to rule #2) 2. Choose eligible price that is closest to the reference price (usually the last quoted price) Trade execution priorities on Euronext: 1. Price priority (highest for buyers, lowest for sellers) 2. Member (since Nov. 2007) 3. Time at which the order is displayed 22

23 3- Theoretical volume =Min{Cum. Demand,Cum. Supply} Call auction Buy Sell MO MO Orders Cum Demand Cum Supply Supply and demand Theo vol Excess demand Excess supply Traded volume maximized 4- Excess when of supply opening price set to 85 and demand Traded volume = 825 shares Buy book after Sell

24 Broker, dealer or hybrid market? Order-driven market (or broker based market) Brokers are not allowed to conduct proprietary trades. Brokers are the agencies of final customers agency market. The order book is the sole trading venue. This is the way trades used to be organized in Paris from 1807 to 1972 (from a legal point of view), 1991 (in reality). Quote-driven market (or dealer based market) Dealers or market makers quote bid-ask spreads. Final customers never trade directly: trades always take place with a dealer (e.g. SEAQ and NASDAQ) Example : over the counter interbank market Disappearing for stocks. No major quote-driven stock market nowadays Hybrid markets: all markets The order book is the major source of liquidity but dealers can accomodate some trades. NYSE and its specialists (monopoly dealers) UTP (ex NSC) and active prices' since 1992 (designated market maker) UTP (ex NSC) and liquidity contracts' (since 2004 for shares belonging to CAC40 index!) Xetra and its Betreurs (designated sponsor) 4.Dealer based markets and other market models 24

25 Broker, dealer, crossing markets (1) Broker Dealer Crossing Functioning of the market Order-driven Quote-driven Imported price Order book? Yes No Yes Do limit orders participate to the price discovery process? Yes No No Are VWAP orders available? Yes Yes No Is there non-execution risk? Low The lowest? High Is continuous trading possible? Yes Yes Is continuous trading manadatory? No Yes No Is open-outcry possible? Yes Yes? Is open-outcry inevitable? No No No 4.Dealer based markets and other market models 25

26 Broker, dealer, crossing markets (2) Agency Dealers Crossing Functioning of the market Imported Order-driven Quote-driven price Is there a price discovery process Yes Yes Several Is call-auction possible? auctions No possible Is call-auction mandatory? Yes No Is the price discovery process computer-assisted? Possible, not mandatory Yes during Can traders observe the bid-ask continuous spread? session Yes Are there commissions? 4.Dealer based markets and other market models Yes Automation not possible (so far) No. Net prices. Possible however No, the price is taken from another market Yes 26

27 Stock exchange and liquidity Bid-ask spread Signed trade (buyer- or seller-initiated) Depth Why did depth become smaller after 2007? The impact of tick size on liquidity Resilience Impact of an order Temporary impact Permanent impact 4.Dealer based markets and other market models 27

28 Bid-ask spread - measurement Quoted or posted spread (fourchette affichée) Ask -Bid, where Midpoint = i,t i,t i,t i,t QS i,t = i,t Midpoint 2 i,t Effective spread (fourchette effective) Ask +Bid ES = i,t 2 Price -Midpoint i,t Midpoint i,t i,t ask bid Discount 4.Dealer based markets and other market models 28

29 Demand and supply (with frictions) Price Supply (sellers on the order book) Supply (sellers off the order book) Bid-ask spread Demand (buyers off the order book) Demand (buyers on the order book) Demsetz, Dealer based markets and other market models Cumulative Quantity Figure 3-4, p 87 29

30 Determinants of the spread In a dealer market: minimum wage for the market maker? In a broker market? Anti-competitive practices (making prices noisy) Inefficient (captured) regulation Order-processing costs (to maintain a physical presence on the market) Inventory costs (and their associated risks) Asymmetric information cost Highly positive correlation between spreads and volatility 4.Dealer based markets and other market models 30

31 Signed trade Air Liquide, 14 April 2013 Euronext-Paris Sellers on the book Sellers off the book hit the best bid (from buyers) in the order book? What is the equilibrium price? 4.Dealer based markets and other market models? Buyers on the book 31

32 Price Sequence of transactions: For which reason(s) do the prices move? 32

33 Price Sellers Buyers Bid-ask spread = 35 cents (from 12:37:50 onwards) Tick size is 5 cents. Bid-ask spread is 7 times the tick size An impatient investor (hence off the order book) Will buy at and sell at

34 Depth Lagardère 17 January 2007 Available depth (million ) in the order book at the best limit and cumulated available depth at the best 5 limits Depth increases over time during the trading session 4.Dealer based markets and other market models 34

35 Impact of tick size on prices Trading prices (in circles) They are connected by a line Prices jump from one price to another one Can you see the spread? 4.Dealer based markets and other market models Lagardère, January 17,

36 Expected impact of a lower tick size The tick size defines possible prices What are the effects of lowering the tick size? Smaller spread: the spread is at least as large as the tick size Lower depth: when tick size is large, time priority matters. If tick size is small a trader can jump ahead the best limit by marginally improving the price limit. Small tick size discourages order exposure. Euronext Before Feb. 2007, tick size varied from 1 to 50 cents based on trading price On (and after) Feb 19, 2007, stocks trade on Euronext with a 1 cent tick size What happens? 4.Dealer based markets and other market models 36

37 Intraday spread before and after Relative spread before (stocks with high tick size before) Relative spread after (stocks with high tick size before) Relative spread before (stocks with 1 cent tick size) February 19, 2007 Lower tick size Spreads become slighlty smaller (0.015 %) 4.Dealer based markets and other market models 37

38 Billions Intraday depth February 19, 2007 Smaller tick size Very significant impact on depth Depth amost halved Depth before (stocks with 1 cent tick size before) Depth before (stocks with high tick size before) 4.Dealer based markets and other market models Depth after (stocks with 1 cent tick size before) Depth after (stocks with high tick size before) 38

39 Resilience Ability of stock prices to revert to their original level after a liquidity shock Liquidity shock (e.g. seller-initiated block) Permanent impact (the seller has information and selling the block conveys this info to the market) Temporary impact (liquidity hole, time it takes for liquidity providers to become aware of the block trade and to replenish the order book) 4.Dealer based markets and other market models 39

40 The price impact of a seller-initiated block Price Trading price Efficient Market P p With time lag Trading price P p Informational effect P c P b P c permanent permanent temporary Trading price Block trade Time Block trade temporary Time Trading price No Informational effect P b Kraus & Stoll (1972) block Block trade Time 4.Dealer based markets and other market models Time Block trade Time 40

41 Synthetic measure of illiquidity (1) P P Q Informational value of Valeur informationnelle de l action stock price, µ bidsize ask more and more illiquidity de plus en plus illiquide asksize bid Q ask asksize bid ( bidsize) ask asksize bid bidsize à l initiative d un vendeur (Q<0) à l initiative d un acheteur (Q>0) Seller initiated (Q < 0) Buyer initiated (Q > 0) 2. Les segments d activité d une entreprise de marché 3. Marché d agence 4. Marché de contrepartie et autres modèles 5. La liquidité Profondeur Echelon et liquidité Résilience Impact d un ordre sur les équilibres J. Hamon 41

42 Cost of illiquidity P Cost P Q Cost Cost sell buy sell buy 4.Dealer based markets and other market models Usually, the relationship is not linear 42

43 Synthetic liquidity measure (2) Xetra liquidity measure (XLM) Based on the orders sent to the trading system, Xetra computes the would-be order book as well as the would-be sequence of trades: After including a fictitious buy order ( 25,000) as well as a fictitious sell order ( 25,000 too) every minute Computes the difference between the would-be trading prices (including fictitious orders) and the actual quote midpoint Three classes of liquidity are defined based on this difference Liquid stocks: difference is smaller than 100bp (1%) From100 to 500bp and larger than 500bp Stocks belonging to the most liquid class are not eligible to liquidity-improving trading protocols (no designated sponsors ) 4.Dealer based markets and other market models 43