No. 2011/03 Is BEST Really Better? Internalization of Orders in an Open Limit Order Book. Joachim Grammig and Erik Theissen

Transcription

1 No. 2011/03 Is BEST Really Beer? Inernalizaion of Orders in an Open Limi Order Book Joachim Grammig and Erik Theissen Cener for Financial Sudies Goehe-Universiä Frankfur House of Finance Grüneburgplaz Frankfur Deuschland Telefon: +49 (0) Fax: +49 (0) hp:// info@ifk-cfs.de

2 Cener for Financial Sudies The Cener for Financial Sudies is a nonprofi research organizaion, suppored by an associaion of more han 120 banks, insurance companies, indusrial corporaions and public insiuions. Esablished in 1968 and closely affiliaed wih he Universiy of Frankfur, i provides a srong link beween he financial communiy and academia. The CFS Working Paper Series presens he resul of scienific research on seleced opics in he field of money, banking and finance. The auhors were eiher paricipans in he Cener s Research Fellow Program or members of one of he Cener s Research Projecs. If you would like o know more abou he Cener for Financial Sudies, please le us know of your ineres. Prof. Michalis Haliassos, Ph.D. Prof. Dr. Jan Pieer Krahnen Prof. Dr. Uwe Walz Cener for Financial Sudies Goehe-Universiä House of Finance Grüneburgplaz Frankfur am Main Deuschland Telefon: +49 (0) Fax: +49 (0) hp:// info@ifk-cfs.de

3 CFS Working Paper No. 2011/03 Is BEST Really Beer? Inernalizaion of Orders in an Open Limi Order Book* Joachim Grammig 1 and Erik Theissen 2 January 2011 Absrac This paper sudies he marke qualiy of an inernalizaion sysem which is designed as par of an open limi order book (he era sysem operaed by Deusche Börse AG). The inernalizaion sys-em (era BEST) guaranees a price improvemen over he inside spread in he era order book. We develop a srucural model of his unique dual marke environmen and show ha, while adverse selecion coss of inernalized rades are significanly lower han hose of regular order book rades, he realized spreads (he revenue earned by he suppliers of liquidiy) is significanly larger. The cos savings of he inernalizer are larger han he mandaory price improvemen. This suggess ha inernalizaion can be profiable boh for he cusomer and he inernalizer. JEL Classificaion: G10 Keywords: Inernalizaion, Execuion Qualiy, Adverse Selecion Coss * We hank wo anonymous referees, Miroslav Budimir, Oliver Maurer, Uwe Schweicker and seminar paricipans a he Universiy of Frankfur/Main, KU Leuven, CORE/Louvain-La-Neuve, he Universiy of Poro, ISCTE Lisbon and a Humbold Universiy Berlin for heir helpful commens and Oliver Wünsche for excellen research assisance. We are graeful o Deusche Börse AG for providing access o he daa. Uwe Schweicker offered invaluable experise in he rading sysems and suppor for our work. 1 Universiy of Tübingen, Deparmen of Economics, Mohlsr Tübingen, Germany, joachim.grammig@uniuebingen.de, Phone: , fax: ; 2 Universiy of Mannheim and CFS; Address: Universiy of Mannheim, Finance Area, L5, 2, Mannheim, Germany, heissen@uni-mannheim.de, Phone: , fax:

4 1 Inroducion Inernalizaion is a pracice by which banks or brokers receiving (reail) cusomer orders do no roue hese orders o he exchange bu raher execue hem agains heir own book. Inernalizaion has been, and sill is, a conroversial issue. Proponens argue ha inernalizaion realizes cos savings and can hus be advanageous for boh he bank and he cusomer. Criics, on he oher hand, argue ha inernalizaion resuls in fragmenaion and cream skimming, and may be derimenal o marke qualiy. In he pre-mifid era he EU member saes have aken very differen regulaory sances on inernalizaion. France and Ialy had adaped a "concenraion rule" which required ha all ransacions be processed on a regulaed marke. Such a rule works o prohibi inernalizaion. Oher counries, such as Germany and he UK, allowed inernalizaion. In he UK i was praciced on a large scale. Hansch, Naik and Viswanahan (1999) repor ha 62% of he rades in heir sample from he London Sock Exchange were inernalized. When, in 2002, he commission of he European Union published a draf paper for he Markes in Financial Insrumens Direcive (MiFID) i ook a very liberal approach o inernalizaion. A hefy debae ensued. The final version of he direcive akes a somewha more resricive approach. I allows inernalizaion bu requires inernalizers o "make public heir quoes on a regular and coninuous basis during normal rading hours". In his paper we address he economic issues involved. Inernalizaion, if praciced singlehandedly by brokers, 1 has wo poenial drawbacks (see, e.g., Easley, Kiefer and O'Hara 1996, 1 Single-handed inernalizaion is very common in he US. An example of single-handed inernalizaion in Germany is he PIP program operaed by Deusche Bank unil Ocober

5 Theissen 2002). Firs, inernalized orders are no execued on he exchange bu are raher execued in an in-house marke. This leads o a fragmenaion of he order flow which, in urn, may reduce he rading volume and he liquidiy of he main marke. Second, ypically only orders saisfying specific crieria are inernalized. The mos imporan crieria are ha a) he order is submied by a reail cusomer and b) he order is small. Empirical evidence (e.g. Chakravary 2001 and Linnainmaa 2003) suggess ha reail cusomers submiing small orders are unlikely o possess privae informaion on he value of he asses hey rade. Therefore, he inernalizer faces a low risk of rading wih a beer informed counerpary and, herefore, faces low adverse selecion coss - inernalizers "skim he cream" off he order flow (e.g. Easley, Kiefer and O'Hara 1996). The flip side of he coin is, however, ha he non-inernalized orders which are roued o he main marke have an increased probabiliy of being informed. The adverse selecion risk faced by he suppliers of liquidiy on he main marke hus increases. We analyze era BEST, a sysem inroduced by Deusche Börse AG in era BEST is unique in several respecs. Firs, he sysem requires ha cusomer orders are filled a a price which is more favorable han he price he order would receive if i was roued o he era order book insead. The minimum price improvemen was 1 cen per share during our sample period. 2 Second, era BEST allows inernalizaion on a plaform which is operaed by he exchange. Therefore, he rading volume execued on he exchange is no reduced, and fragmenaion is no much of an issue. Consequenly, in our analysis we focus on he cream skimming hypohesis. We es i by comparing he adverse selecion coss of inernalized orders o hose of orders execued on he main marke. To his end we develop a srucural model of he 2 The minimum price improvemen has been reduced o 0.1 cen in

6 specific dual marke srucure of era BEST. The model is an exension of he approach pu forh in Glosen and Harris (1988) seminal paper. One imporan quesion ha we do no address in his paper is wheher inernalizaion is derimenal o marke qualiy. According o he cream skimming hypohesis inernalizaion divers easy-o-fill orders (i.e., orders which are unlikely o be informaion-based) away from he main marke. Consequenly he adverse selecion coss in he main marke should increase. This yields he predicion ha he inroducion of era BEST leads o an increase in he spreads in he era order book. Tesing his predicion is very difficul for wo reasons. Firs, he marke share of era BEST is very low (1.5% of he number of ransacions, 0.25% of he rading volume; see secion 3). Therefore, any effec on he qualiy of he main marke will be small and will be almos impossible o idenify empirically. Second, he even of ineres - he inroducion of era BEST - occurred a he same ime for all sample socks. In such a seing i is difficul o appropriaely conrol for oher facors affecing liquidiy (see Maher, Swan and Weserholm 2008). For hese reasons we do no aemp o analyze wheher he qualiy of he main marke has changed upon inroducion of era BEST. Raher, we analyze era and era BEST ransacions wih respec o he qualiy of execuion, he magniude of he adverse selecion coss, and he realized spread earned by he suppliers of liquidiy. Our resuls provide clear evidence of cream skimming. Realized spreads 3 are significanly higher for orders execued in era BEST han for orders execued in era, and adverse selec- 3 The effecive bid-ask spread, defined as he difference beween he ransacion price and he midpoin of he bes bid and he bes ask quoe a he ime he ransacion occurs, is a widely used measure of he implici ransacion cos of a rade. The effecive spread can be decomposed ino a porion ha measures he losses of he suppliers of liquidiy o raders wih superior informaion (he adverse selecion componen) and he re- 3

7 ion coss in era BEST are significanly lower han hose in he main marke. Inernalizers hus earn realized spreads ha are larger han hose earned by he suppliers of liquidiy on he main marke. This is rue even afer aking ino accoun he mandaory price improvemen. Consequenly, inernalizaion can be profiable boh for he cusomer (who receives he price improvemen) and for he broker (who earns a large realized spread). The amoun of he minimum price improvemen deermines how he cos savings are shared beween he cusomer and he inernalizing bank or broker. Our paper is relaed o previous sudies of inernalizaion and he relaed phenomena of preferencing and paymen for order flow. 4 On balance, hese papers conclude ha marke qualiy is no negaively affeced by inernalizaion. There appears o be, however, some evidence of cream skimming, as documened in Easley, Kiefer and O'Hara (1996). Our paper offers hree conribuions o his lieraure. Firs, we analyze he effecs of inernalizaion in a fully elecronic aucion marke. This conrass wih previous papers analyzing he floor-based specialis sysem of he NYSE or he dealer markes of Nasdaq and he London Sock Exchange. maining porion, he realized spread. The realized spread covers he order processing coss and also capures profis he suppliers of liquidiy may be earning. 4 Baalio, Jennings and Selway (2001), Hansch, Naik and Viswanahan (1999) and Peerson and Sirri (2003) compare execuion coss for preferenced and non-preferenced orders. Baalio (1997) and Baalio, Greene and Jennings (1997) analyze wheher he execuion qualiy of he main marke was affeced by he inroducion of preferencing and paymen for order flow arrangemens. Easley, Kiefer and O'Hara (1996) compare he probabiliy of informed rades on wo exchanges known o execue a large fracion of purchased order flow o he probabiliy of informed rading on he NYSE. Bloomfield and O'Hara (1998) analyze he effec of preferencing in an experimenal seing. Baalio and Holden (2001), Kandel and Marx (1999) and Parlour and Rajan (2001) develop heoreical models of paymen for order flow arrangemens. 4

8 Second, we analyze inernalizaion on a sysem ha is operaed by he exchange iself. The German Sock Exchange has deliberaely implemened rules aiming a miigaing he poenially adverse effecs of inernalizaion on he qualiy of he main marke. Third, he paper proposes a new mehodology o esimae spread componens in parallel markes. Our exension of he Glosen and Harris (1988) model has several poenial applicaions, e.g. i could be used o analyze he compeiion beween a regulaed marke and an elecronic communicaion nework (ECN). The remainder of he paper is organized as follows. In secion 2 we describe era BEST in deail. In secion 3 we inroduce our daase and presen descripive saisics. Secion 4 develops he empirical mehodology and presens and discusses he main resuls. Secion 5 concludes. 2 Marke Srucure era is an anonymous elecronic open limi order book. Trading sars a 9 a.m. wih an opening call aucion and (during our sample period) ends a 8 p.m. wih a closing aucion. 5 There are wo inraday call aucions a 1 p.m. and 5.30 p.m. Liquidiy is supplied by limi order raders. Orders are mached based on price and ime prioriy. For less liquid socks here are designaed marke makers, bu his does no apply o our sample socks. Alhough era faces compeiion from several floor-based exchanges (he larges being he Frankfur Sock Exchange) i is he dominan marke for German blue chips. Is marke share is well above 90%. 5 Since November 2003, he closing aucion akes place a 5.30 p.m. and here is only one inraday aucion. 5

9 era BEST was inroduced in Sepember 2002 and is an inegral par of era. 6 era members (brokers and banks) who ac as so-called bes execuors have he righ o execue qualifying cusomer orders agains heir own accoun using era BEST as a rading plaform. The bes execuors are hus acing as marke makers. Only marke orders and markeable limi orders 7 submied by reail cusomers are eligible for execuion in era BEST. Orders execued in era BEST receive a mandaory price improvemen o be graned by he bes execuor. The execuion price is a leas one cen per share (he minimum price incremen in era 8 ) beer han he reference price. The reference price, in urn, is he price a which he order would execue if i was submied o era insead. For orders no exceeding he deph a he bes bid or ask, he reference price is he bes bid or ask. For orders exceeding he deph a he bes quoes he reference price is calculaed as he volume-weighed average of he relevan limi orders in he book. In his case all limi orders in he book ha are priced beer han he reference price are execued ("clean-up prin"). Therefore, price prioriy is no violaed. Brokerage commissions do no depend on wheher an order is execued as a regular era rade or as a era BEST rade. The bes execuor specifies he maximum volume she is willing o rade on eiher side of he marke, and he amoun of price improvemen ha is graned, and eners he corresponding 6 In 2007 era BEST has been redesigned. Among he mos imporan changes is a reducion of he minimum price improvemen from 1 cen o 0.1 cen. The descripion in he ex refers o he version of era BEST which was in operaion during our sample period. 7 A markeable limi order is a limi order o buy wih a price limi ha is equal o or higher han he curren bes ask or a limi order o sell wih a price limi ha is equal o or lower han he curren bes bid. Markeable limi orders are reaed like marke orders; i.e., hey are immediaely execued agains he curren bes bid or ask. 6

10 values ino he sysem. 9 I is imporan o noe ha hese parameers are general insrucions o he rading sysem ha are no changed frequenly. Hence, he bes execuer is no in a posiion o decide wheher a specific order will be inernalized or roued o he era order book. This implies ha he bes execuor canno condiion execuion in era BEST on he curren spread in he order book. This lack of discreion may make inernalizaion unaracive a firs sigh. Remember, hough, ha he cream skimming hypohesis inroduced above is predicaed on he assumpion (and on supporive empirical evidence) ha small orders submied by reail cusomers are less likely o be based on superior informaion. If his is a case, a division of he order flow based on general insrucions is sufficien o aain cream skimming. When a era BEST-eligible order is submied, he sysem checks wheher he size of he order exceeds he maximum volume specified by he bes execuor. I furher checks wheher he order is submied during a call aucion in era. In boh cases he order will no be execued via era BEST bu is auomaically roued o he era order book. The sysem also checks wheher he price improvemen would resul in a zero or negaive spread. If he spread in he era order book is one cen, hen a one cen price improvemen resuls in a negaive spread for he inernalizer. To see his, assume he curren bes bid and ask prices are and 10.01, respecively. A one cen price improvemen implies ha he inernalizer sells a (one cen lower han he curren bes ask) and buys a (one cen higher han he curren bes bid). The resuling spread is negaive. By he same argumen, a wo-cen spread in he order book will resul in a zero-spread for he inernalizer. In boh cases he order will no be execued via era BEST bu is auomaically re-roued o he era order 8 9 The minimum ick size in era has been reduced in 2007, afer he end of our sample period.. Bes execuors can choose o offer price improvemens larger han 1 cen. 7

11 book. This is a highly relevan case because one- and wo-cen spreads are very common for liquid socks. era BEST is fully pos-rade ransparen. Inernalized ransacions are repored immediaely and are marked as "B". This allows marke paricipans o disinguish era BEST ransacions from regular order book rades. The sysem allows for order flow provision agreemens. Under such an agreemen, a broker who is no a bes execuor may roue eligible cusomer orders o a bes execuor. In urn, he broker may receive a paymen for he order rouing. 10 Obviously, such an arrangemen shares many similariies wih he pracice of paymen for order flow in he US. I has been argued ha inernalizaion, when praciced on a larger scale, may adversely affec he qualiy of he main marke (see Biais and Davydoff 2002 and he lieraure addressing he cream skimming argumen referred o earlier). In an aemp o counerbalance his effec, bes execuors are required o ac as "liquidiy managers" in he regular era order book for hose socks for which hey ac as a bes execuor. A liquidiy manager has o conribue o he liquidiy of he order book by submiing limi orders. A bes execuor obviously has no incenive o improve he liquidiy in he order book, as his would reduce he revenues earned on he inernalized orders. Therefore, requiring he bes execuors o ac as liquidiy managers will only serve is purpose if he obligaions of a liquidiy manager are exacly specified and also enforced. Maximum spread requiremens exis for non-da socks bu no for he componen socks of he DA (which consiue our sample) Unforunaely, we do no have access o informaion on he frequency and magniude of such paymens. I would be very ineresing o empirically analyze he exen o which he liquidiy managemen aciviies of he bes execuors affec he liquidiy in he order book. This would, however, require a daase which conains 8

12 Given he design of era BEST a reail cusomer who has decided o rade shares using a marke order 12 is always beer off having her order execued in era BEST as compared o he era order book. The inernalizer poenially benefis from he low adverse selecion coss (see he cream skimming argumen oulined above). On he oher hand, he has o gran he price improvemen. The relaive magniude of he cos advanage and he price improvemen deermines wheher inernalizaion is profiable. Wheher his is he case is a quesion we ry o answer in our empirical analysis. 3 Daa Our daa se covers eigh socks and he period Ocober 2002 hrough January 2003, a oal of 84 rading days. The sample socks are German blue chip socks, and hey are all among he consiuen socks of he DA index. For each of he sample socks we have a complee record of all ransacions in era and era BEST. If a marke order or markeable limi order walks up or down he era order book (i.e. he order volume exceeds he deph a he bes quoe), he resuling ransacions are recorded as one ransacion a he volume-weighed average price. Besides he ransacion price he daa include he exac ime of he rade, he volume of he rade, an indicaion wheher he rade was buyer- or seller-iniiaed, and an indicaor idenifying rades execued in era BEST. Inser Table I abou here all limi orders submied o he marke and reveals he ideniy of he order submier. Such a daa se is, unforunaely, unavailable. 12 The price improvemen makes marke orders relaively more aracive. Therefore, he design of era BEST may also have implicaions for he choice beween marke orders and limi orders. 9

13 Table I presens descripive saisics. The figures confirm ha he sample socks are indeed highly liquid. Even he leas frequenly raded sock has more han 70,000 ransacions in he sample period which corresponds o roughly 860 ransacions per day. The marke share of era BEST is raher low. Measured in number of ransacions, he era BEST marke share amouns o 1.5% averaged across socks. Furhermore, ransacions in era BEST are much smaller han regular order book rades. Measured in Euro rading volume, he era BEST marke share is only abou 0.25%. As noed previously, he rading sysem auomaically checks wheher he price improvemen would resul in a zero or negaive spread. If so, he order will no be execued in era BEST bu will be roued o he order book. There are hus orders ha were originally enered as era BEST orders bu were evenually execued in he order book. In our daa se hese ransacions are coded as order book rades, no as era BEST rades. Given ha one- and wo-cen spreads are quie common for he mos liquid socks, he figures provided in Table I are likely o undersae he marke share of era BEST. 4 Mehodology and Resuls A variey of procedures o esimae he spread and is componens has been proposed in he lieraure. In his paper we employ wo differen approaches. We firs compue realized spreads o measure he revenue earned by he suppliers of liquidiy. We hen develop a srucural model ha is used o esimae he adverse selecion and order processing componens of he spread in era and era BEST. For ha purpose, we modify he Glosen and Harris (1988) approach o accoun for he specific dual marke srucure under scruiny. We also esimae a resriced 10

14 version of he model which is similar o he models considered by Huang and Soll (1997) and Madhavan, Richardson and Roomans (1997). 4.1 Realized Spreads Following Huang and Soll (1996) realized (half) spreads are obained by relaing he price of a ransacion o he quoe midpoin prevailing a specified ime span τ (e.g. 5 minues) afer he rade. The fuure midpoin serves as an esimae of he asse value. Relaing he ransacion price o his esimae of he asse value and averaging across rade evens resuls in an esimae of he liquidiy suppliers gross revenue. As our daa do no conain bid-ask quoes, we canno use he fuure quoe midpoin o compue realized spreads. We herefore proceed as follows. We mach each buyer-iniiaed rade wih he firs seller-iniiaed rade afer a leas τ = 5 minues, and similarly we mach each selleriniiaed rade wih he firs buyer-iniiaed rade afer a leas τ = 5 minues. 13 As a robusness check we have repeaed he esimaion using τ = 1 minue and τ = 10 minues. The resuls were very similar and are herefore omied from he paper. Formally, le a P and b P denoe he ransacion prices for a ime buyer-iniiaed rade (i.e., a rade a he ask price) and a seller-iniiaed rade (a he bid price), respecively. Then he expressions R a b s P P (1) 13 Regular era rades and era BEST rades are pooled. Thus, a regular era rade a ime may be paired wih a fuure regular era rade or a era BEST rade, and similarly a era BEST rade a ime can be paired wih a fuure regular era rade or a era BEST rade. 11

15 if he iniial ransacion was a he ask and s P P (2) R a b if he ransacion a ime was a he bid, provide esimaes of he realized spread. If he firs rade ha occurs a leas 5 minues afer he iniial rade is equally likely o be buyer- or selleriniiaed, our approach will, in expecaions, yield he same resul as he procedure ha uses he fuure midpoin. 14 Resuls are presened in Panel A of Table II. The (unweighed) average realized spread in era is 0.76 cens per share. The corresponding value in era BEST is more han wice as high. Here, he average realized spread amouns o 1.82 cens. The relaion ha he realized spread in era BEST is higher han he realized spread in era holds for all sample socks. Noe ha he figures for era BEST already incorporae he price improvemen. Thus, even afer graning he price improvemen he realized spread earned by he inernalizer is larger han he realized spreads earned by he suppliers of liquidiy in he era order book. This implies ha he subse of orders execued in era BEST yields higher profis for he suppliers of liquidiy han regular order book rades. A possible explanaion (o be elaboraed below) is ha adverse selecion coss are lower in era BEST. The analysis so far did no ake ino accoun ha he average rade size in he wo rading venues is differen. We herefore repea he analysis bu now exclude all rades in he era order 14 Alhough he order flow may be serially correlaed, his correlaion is unlikely o persis for five minues. Even he leas liquid sock in our sample has a ransacion frequency which corresponds o an average iner-rade duraion of less han one minue. Our assumpion ha he firs rade afer five minues is buyer- or selleriniiaed wih equal probabiliy is, herefore, innocuous. 12

16 book ha are larger han he larges rade in era BEST for he sock under invesigaion. The resuls are also presened in Table II. The average realized spread in era now amouns o 0.86 cens, 0.1 cens larger han he average for he unresriced sample. This suggess ha realized spreads are negaively relaed o rade size. Realized spreads are sill larger in era BEST for all sample socks. The difference is saisically significan a he 5% level for all bu wo socks (see he las column in Panel A of Table II). Inser Table II abou here Resricing he sample o rades ha do no exceed he maximum rade size in era BEST is a raher crude way o conrol for size dependence. To check he robusness of he resul, we perfom an addiional regression analysis ha explicily conrols for he effec of rading volume on he realized spread. Specifically, we esimae he regression s B V (3) R ln for each sock separaely. B is a dummy variable idenifying ransacions in era BEST and V is he volume, measured by he number of shares, of ransacion. Order book rades wih a size exceeding he maximum rade size in era BEST are excluded from he analysis. 15 The resuls shown in Panel B of Table II confirm he negaive relaion beween realized spread and volume. The corresponding coefficien esimaes are negaive and significan for all sample socks. Our previous finding ha realized spreads are significanly higher in era BEST is confirmed for six of he eigh sample socks. For he remaining wo socks he difference in realized spreads is insignifican wih one coefficien esimae being posiive and he oher one negaive. The analysis of he realized spreads hus provides evidence ha inernalizaion in 15 We have also esimaed he model using all observaions. The resuls are virually idenical. 13

17 era BEST is profiable. Realized spreads for era BEST rades are - even afer aking he mandaory price improvemen ino accoun - higher han realized spreads for regular era rades. In he nex secion we develop and es a srucural model of he specific dual marke srucure in order o gain insighs ino he reasons for he differences we uncovered. 4.2 A Srucural Model of he Dual Trading Environmen Given ha our daa allows idenificaion of rades as buyer-iniiaed or seller-iniiaed, ye do no conain quoe informaion, i is naural o employ a spread decomposion model along he lines of Glosen and Harris (1988), Huang and Soll (1997) and Madhavan, Richardson and Roomans (1997) for a comparison and decomposion of ransacion coss in era and era BEST. In he conex of he presen paper, he Glosen and Harris (1988) model is he mos suiable framework. As documened in Table I, average rade sizes in era and era BEST are quie differen. As he execuion coss and heir componens may depend on rade size, a model ha accouns for rade size is warraned. The Glosen-Harris model is he only model o include rade size as an explanaory variable. Boh Huang and Soll (1997) and Madhavan, Richardson and Roomans (1997) assume a consan rade size. When he rade size in he Glosen-Harris model is assumed o be consan, he model reduces o he Huang-Soll model and he Madhavan, Richardson and Roomans model (wih he addiional resricion of zero correlaion in he order flow). Besides our full model we also esimae such a resriced version. The basic idea of he Glosen and Harris (1988) model is ha he bid-ask spread consiss of wo componens. The firs componen allows he marke makers (or, more generally, he sup- 14

18 pliers of liquidiy) o cover heir cos of doing business and o possibly earn a profi. This componen of he spread is unrelaed o he value of he asse and is, herefore, ransiory. I only causes he prices of subsequen ransacions o "bounce" beween he bid price and he ask price. The second componen arises because he suppliers of liquidiy, wih posiive probabiliy, rade wih beer informed invesors. Bu hen he fac ha a ransacion ook place may reveal new informaion abou he asse value. Suppliers of liquidiy will updae heir beliefs accordingly and will adjus boh heir bid and ask prices. These price changes are relaed o he value of he asse and are herefore permanen. If he suppliers of liquidiy only adjus heir bid and ask prices afer he ransacion bu do no widen he spread hey would incur losses. Afer selling hey would realize ha he value of he asse is higher han hey previously hough and ha hey sold a oo low a price (and vice versa afer buying). To proec agains hese losses he suppliers of liquidiy will increase he bid-ask spread beyond he level ha would obain in a world wihou informaion asymmeries. 16 The second componen of he spread is herefore referred o as adverse-selecion componen. In he Glosen and Harris (1988) model he adjusmen of he quoes afer a rade will depend on he informaion conen of he ransacion. The original Glosen and Harris (1988) model assumes ha marke paricipans learn a) he direcion of he rade (i.e., wheher i was buyeriniiaed or seller-iniiaed) and b) he ransacion volume. The rade direcion deermines he sign of he change in he quoes, he volume deermines he size of he change. The inuiion for he size-dependence is as follows. Traders possessing superior informaion will prefer o make large rades. Bu hen, he probabiliy ha he counerpary o a rade possessed superior 15

19 informaion is a funcion of rade size. Larger rades are more likely o have been iniiaed by invesors wih superior informaion and are, herefore, more informaive. In our applicaion he suppliers of liquidiy have more informaion han in he original Glosen and Harris (1988) model. Besides rade direcion and rade size hey also observe wheher he ransacion ook place in era or in era BEST. The cream skimming argumen discussed earlier predics ha raders in era BEST are less likely o possess superior informaion. Bu hen we should expec ha he change in he bid and ask quoes is smaller afer a rade in era BEST han afer a rade in he era order book. Our modificaion of he Glosen and Harris (1988) model allows us o es wheher his is indeed he case. This is our approach o es he cream skimming hypohesis. In he following we show how he Glosen and Harris (1988) model can be adaped o he dual marke srucure of era and era BEST. Le Q be a rade indicaor aking on he value 1 if ransacion is buyer-iniiaed and -1 if i is seller-iniiaed. Transacion price and share volume of ransacion are denoed by P and V, respecively. Le M denoe he midpoin of he bes bid and ask quoaion in he order book a he ime ransacion occurs. We assume ha M evolves according o M M 1 B Z Q B Z Q, (4) B where J Z is he adverse selecion componen of he spread. I is equal o he amoun by which he suppliers of liquidiy adjus heir quoes afer observing a ransacion. The index J, B refers o he era order book () and era BEST (B), respecively. B is a dummy variable aking on he value one if ransacion occurs in era BEST and zero oherwise. The 16 This is he inuiion underlying he Glosen and Milgrom (1985) model. 16

20 inuiion behind equaion (4) is simple. The suppliers of liquidiy incorporae he informaion revealed by ransacion -1, measured by he adverse selecion componen Z J 1, ino heir bid and ask prices. The adverse selecion componen represens he informaion conen of he rade. I is allowed o be differen for ransacions in era and era BEST, respecively. Public informaion releases, which will also affec he quoes, are incorporaed ino he zero mean and serially uncorrelaed random variable. The adverse selecion componen is assumed o depend linearly on he size of he ransacion, Z z z V. (5) J J J 0 1 From (4) and (5) we obain he change in he quoe midpoin B B M M z Q z Q V z z B Q z z B Q V. (6) The bid and ask prices are based on he expeced values of he asse condiional upon he characerisics (i.e., direcion and size) of he nex rade. They furher incorporae he emporary componen of he spread inroduced earlier. For rades in he era order book he ransiory componen, denoed C, is assumed o depend linearly on rade size, C c c V. (7) 0 1 Consequenly, he price for ransacion if i occurs in era can be wrien as P M z z V c c V Q (8) where z0 z1 V c0 c1 V is he half spread and he zero mean random variable capures random noise, rounding effecs ec. This formulaion implies ha he ransacion price is coningen upon he size of he rade which is in line wih models of limi order markes such 17

21 as Glosen (1994). I is also consisen wih our daa. Remember ha ransacions riggered by marke orders walking up or down he book are recorded as one ransacion a he volumeweighed average price in our daa se. The prices of hese ransacions are clearly coningen on rade size. Transacion prices in era BEST are no deermined independenly. Raher, hese prices are derived from he bid and ask prices prevailing in he era order book. An invesor buying in era BEST pays he curren era ask price minus he price improvemen. Similarly, an invesor selling in era BEST receives he curren era bid price plus he price improvemen. As noed previously, he size of he price improvemen is fixed by he bes execuor (ypically he minimum value of one cen per share) and is no changed during he rading day. Therefore, we rea he price improvemen as a consan and denoe i by. For a ransacion occurring in era BEST he ransacion price is hen P M z z V c c V Q. (9) Combining (8) and (9) yields he following expression for he ransacion price: P M B z z V c c V Q B z z V c c V Q M z z V c c V Q B Q (10) Firs-differencing, insering (6) and rearranging erms yields our basic model P z Q z QV c Q Q c QV Q V B B z0 z0 B 1Q 1 z1 z1 B 1Q 1V 1 B Q B 1Q 1 (11) where 1. Equaion (11) can be esimaed by OLS o obain esimaes of boh he ransiory and he permanen componen of he spread as a funcion of rade size. We obain 18

22 wo such ses of esimaes, one for ransacions in he era order book (denoed by a superscrip ) and one for ransacions in era BEST (denoed by a superscrip B). Noe ha for B, equaion (11) reduces o equaion (2) in Glosen and Harris (1988). B 1 0 We have argued ha he Glosen and Harris (1988) model is more adequae for our purpose han he Huang and Soll (1997) and Madhavan, Richardson and Roomans (1997) models because only he Glosan and Harris model allows he componens of he spread o depend on rade size. However, given he populariy of he Huang and Soll and Madhavan, Richardson and Roomans models, and as a robusness check, we also esimae a version of our model which assumes a consan rade size V. The adverse selecion componen and he ransiory componen in he era order book are hen 0 i 0 i z z V; c c V. The adverse selecion componen in era BEST is B B z0 zi V. 17 Subsiuing hese expressions ino equaion (11) yields he following simplified model: * P Q Q Q B Q B Q B Q. (12) B This model assumes a consan rade size V, and J, J, B componen in marke J, adaped o his consan rade size. Similarly, denoes he ransiory componen of he spread, adaped o he consan rade size., is he adverse selecion 17 Noe ha here is no ransiory componen in era BEST. This holds because prices in era BEST are derived from he bid and ask quoes in era. Transacions in era BEST are execued a a price equal o he era price plus / minus he price improvemen. 19

23 Noe ha for B 1 0 equaion (12) corresponds o equaion (5) in Huang and Soll B (1997), and i also corresponds o equaion (4) in Madhavan, Richardson and Roomans (1997) wih he addiional resricion ha Q is serially uncorrelaed. 4.3 Esimaion Resuls We sar our analysis wih he esimaion of our basic model. For his purpose we esimae equaion (11) for each sock using OLS and compue Newey-Wes sandard errors o accoun for he serial correlaion caused by he specific srucure of he disurbance erm presened in Table III.. Resuls are The explanaory variables explain a significan porion of he price changes. This is evidenced by R 2 values ranging from 0.27 o The adverse selecion componen for regular era rades is significan for all sample socks. I depends posiively on rading volume (i.e., z1 0 ) as models such as Glosen (1994) predic. The ransiory componen is characerized by a posiive inercep and a negaive relaion o rade size (i.e., c1 0). This suggess economies of scale in he execuion of rades. 18 These are, however, overcompensaed by he in- crease in adverse selecion coss, as is evinced by he fac ha z1 c1 for all sample socks. The adverse selecion componen in era BEST is significanly smaller han is era coun- B erpar. The inercep z 0 is significanly lower han z 0 for all sample socks whereas here are 18 The bid-ask spread mus offer suppliers of liquidiy a compensaion for he order processing coss. These coss are likely o be, a leas parially, fixed per ransacion. Consequenly, he required compensaion on a pershare basis (which is refleced in he order processing componen of he spread) is declining in rade size. This provides an economic inuiion for he negaive value of he parameer c 1. 20

24 (wih one excepion 19 B ) no significan differences in he slope coefficiens z 1 and z 1 which B measure he relaion beween he adverse selecion cos and rade size. A comparison of z 0 o z 0 reveals ha he adverse selecion componen for small era BEST rades is close o zero. Thus, here is clear evidence of cream skimming. Inser Table III abou here The mos surprising resuls are hose for he effecive price improvemen. We should expec a posiive coefficien close o 0.01, corresponding o he minimum price improvemen of one cen. I urns ou, however, ha he effecive price improvemen is smaller han 0.01 for all sample socks and is even significanly negaive for hree of he sample socks. We will provide an explanaion for his resul in secion 4.4. Table IV presens he resuls of he resriced model (12) which assumes a consan rade size. They are perfecly consisen wih hose of he unresriced model. The era adverse selecion componen, ( ) is posiive and significan for all socks. In all cases he esimaes are slighly larger han he esimaes of z 0 in Table III. This is expeced, given ha z 0 is he in- ercep of he adverse selecion componen (i.e., z 0 is he adverse selecion componen for a rade of size zero) and ha he adverse selecion componen was shown o increase wih rade size. The esimaes of he ransiory componens,, are also significan and posiive, and 19 As for his sock (DBK) he slope in era BEST is larger, he adverse selecion componen will be larger in era BEST han in era for large rades. The rade size ha makes he adverse selecion componen in boh rading sysems equal is 1,437 shares and is larger han he maximum rade size observed in era BEST which is 1,200 shares. We can hus safely conclude ha he adverse selecion componen is smaller in era BEST for DBK, oo. 21

25 slighly smaller in magniude han he esimaes of c 0. This is again expeced since c 0 is he inercep of he ransiory componen (i.e., c 0 is he ransiory componen for a rade of size zero), and he ransiory componen was shown o decrease wih rade size. The adverse selecion componen in era BEST, B, is significanly smaller han. In fac, i is close o zero for mos of he sample socks. This is also consisen wih he resuls of he unresriced model. The esimaes of he effecive price improvemen are slighly larger han hose in Table III bu show he same paern. They are all smaller han 0.01, and we obain significan negaive esimaes for he same hree socks as before. Inser Table IV abou here The resuls of he rade indicaor models can be summarized as follows. The resriced and he unresriced models yield remarkably similar resuls. There is clear evidence of cream skimming. The adverse selecion componen is smaller in era BEST for all sample socks. The mandaory price improvemen does no fully compensae for he differences in adverse selecion coss. In fac, he effecive price improvemen is much smaller han he required minimum price improvemen of 1 cen and is even negaive for hree of he sample socks. 4.4 Discussion The finding ha he effecive price improvemen we esimae is smaller han one cen, and in some cases is even negaive, is surprising a firs sigh. Given ha a rade can only be execued in era BEST when he ransacion price improves on he price in he order book by (a leas) one cen, one would expec ha he effecive price improvemen mus be one cen. We offer wo, no muually exclusive, explanaions for our surprising finding. The firs explanaion is 22

26 based on he design of he rading sysem. Remember from secion 2 ha cusomer orders canno be execued in era BEST when execuion would resul in a negaive or zero spread. This implies ha we do no observe execuions in era BEST a imes when he spread in he order book is one cen or wo cens. Thus, condiional upon observing a era BEST rade, he spread in he order book is large. Consider he following illusraive example: Assume he spread is 1, 2, 3 or 4 cens, each wih equal probabiliy. If ransacions occur randomly he effecive half-spread is 0.5, 1, 1.5 or 2 cens wih equal probabiliy and hus is 1.25 cens on average. Transacions in era BEST only occur when he spread is 3 or 4 cens, however. The effecive half-spread is hus eiher 0.5 cens (1.5 cens minus he 1 cen price improvemen) or 1 cen (2 cens minus he 1 cen price improvemen); on average i is 0.75 cens. The difference in he effecive half spread is 0.5 cens (1.25 cens for rades in he order book and 0.75 cens for rades in era BEST), only half he magniude of he price improvemen. The second explanaion is based on he iming of ransacions. The quoed spread in he era order book is no consan bu raher varies over ime. Consequenly, raders can reduce he effecive spread hey pay by submiing heir marke orders a imes when he quoed spread is low. Timing a ransacion in his way requires real-ime informaion abou he prevailing bidask spread. Access o his informaion is resriced, however. Informaion on bes bid and ask quoaions is available via he inerne only wih a 15 minue delay. Real ime daa mus be purchased. Reail cusomers whose orders are inernalized are unlikely o purchase his informaion. Consequenly hey are a an informaional disadvanage because hey are unable o ime he submission of heir orders. This, in urn, will increase he average effecive spread paid by hese cusomers. We refer o his effec as he iming disadvanage. The iming disad- 23

27 vanage will be larger for socks which have more pronounced inradaily flucuaions in he spread. We illusrae he iming disadvanage wih a simple example. Assume he spread is eiher 5 cens or 10 cens. Insiuional raders (who rade in he order book) ypically have access o real-ime informaion on quoed spreads and hus will end o rade when he spread is 5 cens. We hen observe an average effecive half-spread for order book rades of 2.5 cens. Now assume ha reail invesors whose orders are execued in era BEST do no have access o realime informaion. They are hus equally likely o rade on a 5-cen or on a 10-cen spread. The observed effecive half spread (aking he price improvemen ino accoun) is eiher 1.5 cen or 4 cens; he average is 2.75 cens and is larger han he average effecive half-spread for order book rades. This example is, of course, very sylized. I does illusrae, however, how he lack of access o real-ime quoe informaion may affec effecive spreads in he reail segmen of he marke. The coefficien in our model hus capures hree effecs, namely, 1) he mandaory price improvemen, 2) he fac ha, condiional upon observing a rade in era BEST he spread mus be larger han 2 cens, and 3) he iming disadvanage of reail invesors using era BEST. The relaive magniude of hese opposing effecs depends on he magniude of he price improvemen compared o he size of he spread and he magniude of he inradaily flucuaions of he quoed spread. These flucuaions (as well as he level of he spread) are likely o be larger for higher-priced socks. 20 Thus, for higher priced socks a one cen price improvemen is of relaively lower value han he same price improvemen for lower-priced socks. This argumen implies ha he effecive price improvemen we are measuring wih he parameer 24

28 should be negaively relaed o he price level of he sock. We find supporing evidence for his conjecure. The hree socks wih negaive effecive price improvemen are also he socks wih he highes average prices. The rank correlaion beween he effecive price improvemen and he average price is Summary and Conclusion This paper provides a deailed analysis of inernalizaion in era BEST. This plaform, operaed by Deusche Börse AG as a par of is era sysem, allows paricipaing banks and brokers o inernalize cusomer order flow. An imporan feaure of he sysem is ha he inernalizer has o gran a price improvemen of (a leas) one cen. Thus, he cusomer order will be filled a a price which is more favorable han he price in he era order book a he ime of order submission. I has been argued ha inernalizaion resuls in cream skimming. Inernalized orders are small orders submied by reail cusomers. These cusomers ypically do no possess privae informaion on he value of he securiies hey rade. Consequenly, he inernalized orders are "easy-o-fill" orders which are unlikely o be affeced by adverse selecion effecs. Consequenly, he adverse selecion componen of he spread will be lower for hese orders, and execuing hem will be profiable for he inernalizer. We es he cream skimming hypohesis using a sample of DA socks. We use wo mehodologies. The firs is a spread decomposiion similar o he wo-way decomposiion proposed by Huang and Soll (1996). We find ha realized spreads are unanimously higher in era BEST even afer aking ino accoun he mandaory price improvemen. This indicaes ha 20 Remember ha we measure spreads in Euro, no in percenage erms. 25

29 inernalizaion is indeed profiable. We hen proceed by developing a srucural model of he specific dual marke srucure under scruiny. When esimaing his model we find ha adverse selecion coss in era BEST are considerably smaller han hose in he main marke. This is again consisen wih he cream skimming hypohesis. In conclusion, we find clear evidence in favor of he cream skimming hypohesis. We wish o sress, hough, ha his does no imply ha inernalizaion is bad for he cusomer. On he conrary, a cusomer who has her order inernalized receives a price improvemen which makes execuion in era BEST more favorable han execuion of he same order in he era order book. Our resuls do imply, however, ha he price improvemen which he cusomer receives is smaller han he cos advanage o he inernalizer. Thus, inernalizaion may be profiable boh for he cusomer and he inernalizer. The size of he price improvemen deermines how he profi is shared beween he inernalizer and he cusomer. In his respec, he new version of era BEST, in operaion since 2007, is more favorable o he inernalizers because he required price improvemen has been reduced o 0.1 cen. 26

30 References Baalio, R. (1997), 'Third Marke Broker-Dealers: Cos Compeiors or Cream Skimmers?' Journal of Finance, Vol.52, No.1 (March), pp Baalio, R., Holden, C. (2001), 'A Simple Model of Paymen for Order Flow, Inernalizaion, and Toal Trading Cos', Journal of Financial Markes, Vol.4, No.1 (January), pp Baalio, R., Greene J., Jennings,R. (1997), 'Do Compeing Specialiss and Preferencing Dealers Affec Marke Qualiy?', Review of Financial Sudies, Vol.10, No.4 (Winer), pp Baalio, R., Jennings, R., Selway, J. (2001), 'The Relaionship Among Marke-Making Revenue, Paymen for Order Flow, and Trading Coss for Marke Orders', Journal of Financial Services Research, Vol.19, No.1 (February), pp Biais, B., Davydoff, D. (2002), 'Inernalizaion, Invesor Proecion and Marke Qualiy', Working Paper (July). Bloomfield, R., O Hara, M. (1998), 'Does Order Preferencing Maer?', Journal of Financial Economics, Vol.50, No.1 (Ocober), pp Chakravary, S. (2001), 'Sealh-Trading: Which Traders' Trades Move Sock Prices?', Journal of Financial Economics, Vol.61, No.2 (Augus), pp Easley, D., Kiefer, N., O Hara, M. (1996), 'Cream-Skimming or Profi Sharing? The Curious Role of Purchased Order Flow', Journal of Finance, Vol.51, No.3 (July), pp Glosen, L. (1994), 'Is he Elecronic Open Limi Order Book Ineviable?', Journal of Finance, Vol.49, No.4 (Sepember), pp

31 Glosen, L., Harris, L. (1988), 'Esimaing he Componens of he Bid-Ask Spread', Journal of Financial Economics, Vol.21, No.1 (May), pp Hansch, O., Naik, N., Viswanahan, S. (1999), 'Preferencing, Inernalizaion, Bes Execuion, and Dealer Profis', Journal of Finance, Vol.54, No.5 (Ocober), pp Huang, R., Soll, H. (1996), 'Dealer versus Aucion Markes: A Paired Comparison of Execuion Coss on NASDAQ and he NYSE', Journal of Financial Economics, Vol.41, No.3 (July), pp Huang, R., Soll, H. (1997), 'The Componens of he Bid-Ask Spread: A General Approach', Review of Financial Sudies, Vol.10, No.4 (Winer), pp Kandel, E., Marx, L. (1999), 'Paymens for Order Flow on Nasdaq', Journal of Finance, Vol.54, No.1 (February), pp Linnainmaa, J. (2003), 'Who Makes he Limi Order Book? Implicaions for Conrarian Sraegies, Aenion-Grabbing Hypohesis, and he Disposiion Effec', Working Paper, (Universiy of California Los Angeles, Ocober). Madhavan, A., Richardson, M., Roomans, M. (1997), 'Why Do Securiies Prices Change? A Transacion-Level Analysis of NYSE Socks', Review of Financial Sudies, Vol.10, No.4 (Winer), pp Maher, O., P. Swan and J. Weserholm (2008): Twiligh Falls on he Limi Order Book: Endogeneiy and he Demise of Broker Ideniy. Working Paper, March. Parlour, Ch., Rajan, U. (2001), 'Paymen for Order Flow', Working Paper (Carnegie Mellon Universiy, May). 28

32 Peerson, M., Sirri, E. (2003), 'Order Preferencing and Marke Qualiy on U.S. Equiy Exchanges', Review of Financial Sudies, Vol.16, No.2 (Summer), pp

33 Table I: Descripive Saisics The able presens descripive saisics for our sample. The firs column idenifies he sock. Socks are sored by oal rading volume in he sample period. Columns 2-4 show he number of ransacions, he average rade size in shares and he average rade size in for regular order book rades. Columns 5-7 provide he same informaion for era BEST rades. Sock id # of ransacions era avg. rade size, shares avg. rade size, # of ransacions avg. rade size, shares era BEST maximum rade size, shares avg. rade size, DBK 289,425 1, , , ,200 7,770 DC 324,365 1, , , ,800 5,501 EOS 221,584 1, , , ,020 6,810 BAY 195,192 1, , , ,000 6,128 RWE 155,967 1, , , ,000 6,143 SCH 110, , , ,400 6,979 TKA 91,177 2, , , ,000 4,769 DPW 70,789 1, , , ,000 4,054 30