Beyond the continuous electronic limit order book

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1 Securities Trading: Principles and Procedures Chapter 5 Auctions Copyright 2015, Joel Hasbrouck, All rights reserved 1 Beyond the continuous electronic limit order book The are many ways of arranging markets: Auctions (Ch. 5) Dealers (Ch. 6) Dark pools (Ch. 7) These mechanisms often work alongside a limit order book. But sometimes a combination of auctions/dealers/dark markets can completely replace the continuous book. Copyright 2015, Joel Hasbrouck, All rights reserved 2 1

2 The English Auction One item, one seller, many potential buyers Widely used for art and collectibles Open outcry: bidders can see other bids Bids ascend until one bidder remains. Example: ebay auction of a 1940 s Oilzum thermometer sign (February, 2016) Copyright 2015, Joel Hasbrouck, All rights reserved 3 Bidding history (as of AM, Monday, 15 Feb. 2016) Copyright 2015, Joel Hasbrouck, All rights reserved 4 2

3 Outcomes Assume that a buyer will go up to value (a private limit price ) The final price will be the second-highest value (may plus one tick). Assume that the two highest values are Alan at $2,000 and Beth at $2,500. If Beth bids $2,000, Alan does not rebid. Beth gets it at $2,000 If Alan bids $2,000, Beth bids $2,001. Alan drops out. Beth gets it at $2,001. Copyright 2015, Joel Hasbrouck, All rights reserved 5 The ebay auction is a silent auction: ebay just records and displays the bids. The seller may set a reserve price (a price below which they won t sell) In art auctions, an auctioneer may call out the bids and suggest higher bids. I have $1,000. Do I have $1,200? $1,100? $1,000 going once,, going twice,, going three times, SOLD! A good auctioneer can generate interest and excitement, getting a high price for the seller. Copyright 2015, Joel Hasbrouck, All rights reserved 6 3

4 Alternative auction formats In a sealed-bid auction, bidders don t see other bids. In a descending price auction, the price is set high at the start, and then falls until someone claims the item ( Mine! ) Also called a clock auction. Used in the Netherlands wholesale flower market at Aalsmeer. All these formats can be used when there is one buyer and many potential sellers. Many US towns and cities must by law award a contract to the lowest bidder. Copyright 2015, Joel Hasbrouck, All rights reserved 7 What can go wrong? Collusion Bidders coordinate their bids. I won t bid against you for x if you don t bid against me for y. Manipulation No precise legal or economic definition. Informally: any practice designed to deceive other bidders and distort the price. Copyright 2016, Joel Hasbrouck, All rights reserved 8 4

5 Manipulations In shilling, the seller places her own bids (usually through accomplices) to drive the price up. In bid shielding, a high bid is placed to discourage other bidders, then withdrawn at the last instant. Suppose an antique desk has a value around $10,000. I put in a bid at $500. A partner puts in a bid at $12,000. The $12,000 bid discourages other bidders. Just before the auction ends, my partner cancels (retracts) the $12,000 bid, leaving my $500 bid as the winner. Note: ebay has a strict policy discouraging retractions. Copyright 2016, Joel Hasbrouck, All rights reserved 9 Single-sided multiple unit auctions There are many units available for sale; bids specify quantity as well as price. Used for US Treasury Securities. Auctions regularly run by Federal Reserve Bank of New York. The auction format is sealed-bid Copyright 2016, Joel Hasbrouck, All rights reserved 10 5

6 A single-sided multiple-unit auction Trader Quantity Price Alan 2 $29 Beth 3 $28 Cam 1 $27 Dana 4 $26 Ed 2 $25 Fiona 3 $23 Arrange bids, highest price to lowest. Copyright 2016, Joel Hasbrouck, All rights reserved 11 then fix the supply. If we have nine bonds to sell The lowest accepted bid is $26 (Dana). In a single-price Dutch auction, all bidders pay this price. All bidders above $26 get their full quantities. Dana gets the three remaining units (one less than she wanted). Copyright 2016, Joel Hasbrouck, All rights reserved 12 6

7 A variation: the discriminating pay what you bid auction Alan pays $29 Beth pays $28 Cam pays $27 Dana pays $26 This might seem to raise more money for the seller. But bidders won t be as aggressive. This format increases the incentives for collusion. ( So what were you thinking of bidding? ) Copyright 2016, Joel Hasbrouck, All rights reserved 13 The NY Fed posts auction results to its web site (Treasurydirect.gov) The NY Fed Treasury auction is a primary market. The arrangement used to first sell the securities. Auctions are occasionally used for equity IPOs. See Hambrecht & Quist OpenIPO at Trading after the initial issue of a security is called the secondary market. Auctions are widely used to open and close continuous trading in limit order markets. Copyright 2016, Joel Hasbrouck, All rights reserved 14 7

8 Opening and closing a continuous market Most organized trading is not 24/7. Recall: liquidity is a network externality Trading tends to cluster Many markets adopt implicit or explicit regular trading hours Organized into one or more trading sessions Example: the Tokyo Stock Exchange has a morning session (9:00am - 11:30am) and an afternoon session (12:30pm - 3:00pm) Copyright 2015, Joel Hasbrouck, All rights reserved 15 Volume at the open and close At the open, volume driven by Accumulated portfolio rebalancing needs. Accumulated information. At the close, large volume pegged to closing prices. Mutual funds: closing prices net asset values used to price customer purchases and redemptions. On derivative final settlement days, closing prices used to compute settlement cash flows. Copyright 2015, Joel Hasbrouck, All rights reserved 16 8

9 The typical opening: single-price double-sided auction (SPDA) Double-sided: there are many buyers and many sellers. Order accumulation Buyers are ranked with high bids first. Sellers are ranked with low offers first. Buy orders demand curve; sell orders supply curve. The market clears where the supply and demand curves cross. Copyright 2015, Joel Hasbrouck, All rights reserved 17 Buyers Sellers Buyer Bid Quantity Cumulative Demand Seller Quantity Asking Cumulative Supply Brian $ Seth 3 $2 3 Beth $ Sara 5 $4 8 Ben $ Sasha 4 $6 12 Bev $ Sam 4 $

10 At any price, P: The matched volume in the minimum of supply and demand at P. If (at P) there is excess demand, there is a buy imbalance. If (at P) there is an excess supply, there is a sell imbalance. The net imbalance is the size of the excess. At $9, demand = 4, supply = 12, matched volume = 4, there s a sell imbalance = 8. At $6, demand = 14, supply = 12, matched volume = 12, there s a buy imbalance = 2. At $4, demand =, supply =, matched volume =, there s a buy/sell imbalance =. 19 Determining the clearing price Step 1. Find the price that maximizes the matched volume. Step 2. If there are multiple prices from Step 1, find the price with the smallest net imbalance. Step 3. If there are still multiple prices after Step 2, we can break the ties by: Taking the average of the highest and lowest price, or Taking the price that is nearest to the last closing price of the security. Copyright 2016, Joel Hasbrouck, All rights reserved 20 10

11 Example At $6, the matched volume is maximized at 12. Ben gets a partial fill. Copyright 2016, Joel Hasbrouck, All rights reserved 21 Example At $6: demand = 14; supply = 8; matched vol = 8; buy imbalance = 6 At $7: demand = 10; supply = 12; matched vol = 10; sell imbalance = 2 At $8: demand = 10; supply = 16; matched vol = 10; sell imbalance = 6 Copyright 2016, Joel Hasbrouck, All rights reserved 22 11

12 Example At $3: demand = 16; supply = 8; matched vol = 8; buy imbalance = 8 At $4: demand = 12; supply = 8; matched vol = 8; buy imbalance = 4 At $5, $6, $7: demand = 8; supply = 8; matched vol = 8; imbalance = 0 At $8: demand = 8; supply = 12; matched vol = 8; sell imbalance = 4 $5, $6, and $7 are all candidates for the clearing price Copyright 2016, Joel Hasbrouck, All rights reserved 23 Example (cont) $5, $6, and $7 are all candidates for the clearing price. If the stock last traded at $4, set clearing price to $5 If the stock last traded at $10, set clearing price to $7 Copyright 2016, Joel Hasbrouck, All rights reserved 24 12

13 Example: Citadex session 4, market 3, Tuesday, Feb 2, 2016 At a price of $32, the matched volume is 5 and the net imbalance is zero. One point for a buyer who bought $32 OR who didn t trade, but had a limit price $32. One point for a seller who sold $32 OR who didn t trade, but had a limit price $ Return to the original set of orders At a single clearing price of $6 for all trades The buyers profits are = 28 The seller s profits are = 22 The total profit is $50. These are the gains from trading. Copyright 2015, Joel Hasbrouck, All rights reserved 26 13

14 Economists call the trading profits the surplus. It represents extra value arising gains from trade. It is generally true that a single-price double auction where everyone truthfully reveals their buying and selling limit prices achieves the largest total surplus. BUT: the largest total surplus can also be achieved under alternatives that don t have a single price. We can see this by pairing off the buyers and sellers in different ways. Copyright 2015, Joel Hasbrouck, All rights reserved 27 The profits in an alternative (floor market?) allocation What are the buyers, sellers and total profits if: Seth sells 3 units to $4. Sara sells 1 unit to $5 Sara sells 4 units to $7 Sasha sells 2 units to $8 What is the efficiency of this outcome? Copyright 2015, Joel Hasbrouck, All rights reserved 28 14

15 How do you break the market, to arrive at an inefficient outcome? Pick someone who wouldn t trade in a single-price auction and let him/her displace someone who actually did trade. Suppose Bev buys three units from $3, displacing Brian s purchase. Or, suppose Brian buys three units from $10, displacing Seth s trade. Copyright 2016, Joel Hasbrouck, All rights reserved 29 If it s not necessary to have a single price, maybe we don t need a formal auction. Many floor markets did not have an opening auction. In most of futures pits, traders simply started bargaining (as in Citadex). An electronic limit order market does not need an opening auction. We can just turn on the switch (as in the veconlab simulation). The Shanghai and Shenzen Exchanges (?) This works, but we can have high volatility, with trades occurring in a short period of time at very different prices. Customers ask, Why did I buy at $10, when in almost the same second there were trades at $9? Copyright 2016, Joel Hasbrouck, All rights reserved 30 15

16 Is a single-price auction the best practical solution? Most economists believe: If you replaced the inefficient continuous trading mechanism with a single-price auction, everyone would on average be better off. In practice, auctions can be difficult to run. Next: what can go wrong. Copyright 2016, Joel Hasbrouck, All rights reserved 31 Manipulation Brian puts in two bids His genuine order: buy 4 units, limit $10. and an artificial bid: buy 10 units, limit $11. The second bid discourages the other bidders (Beth, Ben, and Bev). They don t bid at all. At the last instant, Brian cancels his artificial bid. Copyright 2015, Joel Hasbrouck, All rights reserved 32 16

17 After Brian cancels his artificial bid, his original bid for 4 units is the only one left. The clearing price is $4. Brian pays $4 per unit (instead of $6). Copyright 2016, Joel Hasbrouck, All rights reserved 33 Deadline effects When others can see our bids and offers, they can react to them. We should hold off from submitting our best bids and offers until just before the final deadline. This gives our competitors less time to react. Next: the close of the ebay Oilzum Thermometer auction. As of 5:29 PST (Pacific Standard Time) the bid is $1,050 The next bid arrives at 19:18:52 The auction closes at 19:20:45 Copyright 2016, Joel Hasbrouck, All rights reserved 34 17

18 Copyright 2016, Joel Hasbrouck, All rights reserved 35 Notes ebay allows automatic bidding. An automatic bid is programmed to rebid up to a prespecified limit. The time stamps on automatic bids are the original entry times, not the rebid times. The price sequence is correct (even though the time stamps appear out of sequence) At 19:20:38 (with seven seconds left) bidder 938 makes a jump bid. Copyright 2016, Joel Hasbrouck, All rights reserved 36 18

19 In a securities auction, how should we set the deadline? When should we clear the market (that is, stop accepting orders and fix the price)? Because of deadline effects: Everyone waits until the last moment. These can lead to instabilities and manipulations. Should we extend the deadline until outcome looks stable? The auction outcome might never stabilize. In Facebook s IPO, Nasdaq s open was delayed by 30 minutes, required manual overrides of system safeguards, and left Nasdaq short three million shares. Copyright 2015, Joel Hasbrouck, All rights reserved 37 One approach: randomization The auction deadline is a random time (within a narrow window) The London Stock Exchange uses a 6- second window for FTSE-100 stocks. The actual deadline is randomly chosen within this window. You can t submit/cancel at the last moment. Copyright 2015, Joel Hasbrouck, All rights reserved 38 19

20 Randomization vs. risk We re taught that uncertain outcomes involve risk. Security markets are already risky. Doesn t randomization introduce more risk? A random clearing time does not affect fundamental risk. It does not make the dividends or earnings more random. It changes the trading environment in a way that makes the market more fair. Randomization is not used in the US. Copyright 2016, Joel Hasbrouck, All rights reserved 39 Alternative ways of stabilizing an auction Limited disclosure of demand and supply functions. We don t show the full supply and demand curves in real time. We don t see every bid or offer, so we can t react to it. Special order types that work to offset imbalances. Early submission and cancellation deadlines for certain orders. Copyright 2015, Joel Hasbrouck, All rights reserved 40 20

21 The NASDAQ (normal) opening auction ( cross ) Timing NASDAQ systems operate 4am to 8pm. Trading and order entry occurs 7am to 8pm. Regular trading hours are 9:30am to 4pm The opening cross occurs at 9:30am The opening cross operates at the same time as continuous trading. Orders may be marked on open to indicate that they are only to be executed in the opening cross. Copyright 2015, Joel Hasbrouck, All rights reserved 41 There are two limit order books: the opening book and the regular continuous book. They are combined in the open procedure. Opening orders must be received prior to 9:28am and cannot be canceled. Starting at 9:28am, the system transmits matched volume and imbalance information every five seconds. Matched volume and imbalance are computed for a reference price. Please note that the Current Reference Price is determined by the price within the NASDAQ Inside [Best Bid and Offer]where the maximum number of shares are paired, the imbalance is minimized and the distance from the bid-ask midpoint is minimized, in that order. Between 9:28 and 9:30, the system accepts imbalance-only orders. Imbalance only orders are only executed if they reduce the imbalance. Example: if there is a buy imbalance (more buys than sells), a sell imbalance-only order would be executed. Copyright 2015, Joel Hasbrouck, All rights reserved 42 21

22 Closing auctions Many stock and futures exchanges use single-price auctions to close (as well as open) continuous trading. The auction procedures are similar to the opening auction except there is often high volume in the continuous market leading up to the auction. In the NASDAQ closing cross Market on close (MOC) orders can be entered until 3:50 PM Limit on close orders (LOC) are treated as imbalance orders, and can t be cancelled after 3:50 PM Imbalance display starts at 3:50 PM Copyright 2016, Joel Hasbrouck, All rights reserved 43 Deliberate overbidding to set a high price: Background Recall: buying stock with borrowed money (on margin) Suppose that I have $1 Million and I want to buy 500,000 shares of ABC, a $10 stock. I need $5 Million to complete the purchase. My broker lends me the additional $4 Million. My account statement looks like this: Assets Liabilities + NW 500,000 sh $10 $5,000,000 $4,000,000 Loan from broker $1,000,000 Net worth Copyright 2016, Joel Hasbrouck, All rights reserved 44 22

23 The marked-to-market account statement Assets Liabilities + NW 500,000 $10 $5,000,000 $4,000,000 Loan from broker $1,000,000 Net worth If ABC stock goes up to $11 Assets Liabilities + NW 500,000 $11 $5,500,000 $4,000,000 Loan from broker $1,500,000 Net worth If ABC stock goes down to $9 Assets Liabilities + NW 500,000 $9 $4,500,000 $4,000,000 Loan from broker $500,000 Net worth 45 Margin calculations In a long margined position, the margin is computed as: Net worth margin = Market value of stock Initially, margin = $1 Million $5 Million = 0.2 = 20% Brokers set minimum margins. Suppose that this broker s policy is: If the margin drops to 15%, the customer must put up more cash to bring the margin up to 20%. Copyright 2016, Joel Hasbrouck, All rights reserved 46 23

24 At a stock price of $9, the margin is 500,000 4,500,000 = 11% Assets Liabilities + NW 500,000 $9 $4,500,000 $4,000,000 Loan from broker $500,000 Net worth To bring the margin up to 20%, the net worth must be 20% $4,500,000 = $900,000. The customer must put up an additional $400,000. If he does this, the account statement becomes: Assets Liabilities + NW Cash $400,000 $4,000,000 Loan from broker 500,000 $9 $4,500,000 $900,000 Net worth Now the account is in compliance with the margin requirement. Copyright 2016, Joel Hasbrouck, All rights reserved 47 Margin call When an account hits the margin limit, the broker sends the client a margin call. This is a formal notification: put up more cash. If the client does not put up more cash, the broker sells all of the stock, takes the money owed to him, and gives the customer whatever is left. At what point will this account get a margin call? How much will the customer have to put up? Copyright 2016, Joel Hasbrouck, All rights reserved 48 24

25 Assets Liabilities + NW 500,000 $10 $5,000,000 $4,000,000 Loan from broker $1,000,000 Net worth If the stock price is P, market value of stock = 500,000 P net worth = 500,000 P $4,000,000 The margin call will be triggered at 15%, so 500,000 P 4,000,000 = ,000 P 500,000 P 4,000,000 = 75,000 P 425,000 P = 4,000,000 P = $9.41 At this price, the market value of the stock is 500,000 $9.41 = $4,705,000; and, the net worth is $4,705,000 4,000,000 = $705,000 The net worth will have to brought up to 20% $4,705,000 = $941,000 The account needs an additional $941,000 $705,000 = $236,000 If the price hits $9.41, the customer will have to put up $236,000. The customer s dilemma Many margin calculations are based on closing prices. Suppose: it is 3:55 PM, and the last trade in ABC was at $9.40. Customer thinks: If ABC closes at $9.40, I m going to have to come up with about $236,000. I don t have it. Of course, if I bought a few shares in the closing auction, it might drive the closing price up above $9.41, and I can avoid a margin call. 25

26 Manipulation by marking the close / banging the close Putting in orders at the end of the day to influence the closing price. It is illegal. People sometimes attempt it: To avoid margin calls, or To affect the terms of a related transaction. Suppose XYZ is taking over ABC, and agrees to buy all of ABC s ten million outstanding shares at the closing price on a given day. If XYZ can drive the closing price down by $0.01, it will save $ ,000,000 = $100,000. The CFTC and SEC web sites contain many notices of prosecutions in marking-the-close cases. Copyright 2016, Joel Hasbrouck, All rights reserved 51 Other uses of auctions in financial markets Periodic calls for low-activity securities. High-frequency auctions Copyright 2015, Joel Hasbrouck, All rights reserved 52 26

27 Auctions in low-activity securities Some stocks don t trade frequently enough to sustain a continuous market. The Euronext markets (Paris, Amsterdam, Brussels, Lisbon) use twice-daily single-price call auctions to trade stocks that average fewer than 2,500 trades per year. Copyright 2015, Joel Hasbrouck, All rights reserved 53 High-frequency auctions Proposed as a replacement for continuous trading. Run a single-price call every minute. Proponents claim that trading once per minute would satisfy most investors needs remove the millisecond advantages reputedly used by high-frequency traders. Copyright 2015, Joel Hasbrouck, All rights reserved 54 27

28 The Facebook initial public offering (IPO) On Friday, May 18, 2012, Facebook sold about 421 Million new shares at an offering price of $38/share. In the primary market, an investment banking syndicate led by Morgan Stanley bought the shares from Facebook (at $38/share, less commission) and redistributed them to public buyers. Once the shares were in the hands of investors, they could be traded in the secondary market. Facebook chose NASDAQ as its primary listing exchange. Copyright 2015, Joel Hasbrouck, All rights reserved 55 The NASDAQ opening cross for IPOs For the initial opening, orders are entered, canceled and revised during a display-only period (DOP). At the conclusion of the DOP, NASDAQ builds the supply and demand curves, and computes the price and quantity where supply demand. All eligible buyers and sellers are crossed at this price. Continuous trading commences. Copyright 2015, Joel Hasbrouck, All rights reserved 56 28

29 What happened 7:56 NASDAQ announces that the DOP will run from 10:45 to 11:00. 10:58 Net Order Imbalance Indicator suggests an opening price of $43. Morgan requests an extension of the DOP to 11:05 11:05 NASDAQ systems construct a cross. This takes about 20 ms. NASDAQ systems perform a validation check. During the 20 ms computation time, one order had been cancelled. The validation check fails. Copyright 2015, Joel Hasbrouck, All rights reserved 57 NASDAQ recomputes the cross, and performs a second validation check. During this computation, NASDAQ receives two more cancellations, so the second validation step fails. NASDAQ computes the cross (a third time), but fails to register one of cancellations, so the third validation fails. NASDAQ computes the cross (fourth time). One more cancellation. Validation fails. The procedure continues to loop. 11:05 NASDAQ management convenes a code blue conference call. Copyright 2015, Joel Hasbrouck, All rights reserved 58 29

30 The code blue call After a few minutes, the cross failure is attributed to the validation procedure. Is there a way to override the validation procedure? Yes. Move the cross to a duplicate system that has a few lines of code removed (the failover system) 11:25 Management approves this action. 11:30:09 The failover system computes the cross million shares trade at $42. 13:50 NASDAQ learns that 38,000 orders entered between 11:11 and 11:30 weren t included in the cross. NASDAQ determined that it had a 3 million share short position. which it closed (by buying shares at a lower price) at a profit of $10.8 million. Copyright 2015, Joel Hasbrouck, All rights reserved 59 The aftermath NASDAQ pays a US fine of $10 million. and $62 million to brokers. NASDAQ will make technical changes to its Crosses NASDAQ will close its order ports to new orders and cancels after the calculation of a cross is triggered [started] See: U.S. Securities and Exchange Commission, In the matter of the NASDAQ Stock Market LLC and NASDAQ Execution Services LLC ("Facebook"). Copyright 2015, Joel Hasbrouck, All rights reserved 60 30