Locks and Crosses in the Foreign-Exchange Electronic Communication Networks

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2 Locks and Crosses in the Foreign-Exchange Electronic Communication Networks Ly Tran Last updated: Apr 30, 2015 Ly Tran Locks and Crosses 1/25

3 A Normal Limit-Order Book Observation of Abnormality Locks & Crosses by Different Views Contributions EUR, Mar 03, 2008, 9:26 am Price Depth amount Bid Ask Mid-quote Spread > 0, or Bid < Ask Ly Tran Locks and Crosses 2/25

4 Observation of Abnormality Locks & Crosses by Different Views Contributions Locks & Crosses in Limit-Order Book EUR, May 07, 2008, 11:12 am EUR, May 07, 2008, 4:28 pm Price Price Depth amount Bid Ask Mid-quote Depth amount Bid Ask Mid-quote Spread = 0,or Bid = Ask Spread < 0,or Bid > Ask Ly Tran Locks and Crosses 3/25

5 Locks & Crosses not Data Errors Observation of Abnormality Locks & Crosses by Different Views Contributions L&C Locks Crosses Sources FX 32% 8% 24% Nasdaq, Pre-open 35% 11% 24% Cao et al Nasdaq, Reg. hours 11% 9% 2% Shkilko et al NYSE, Reg. hours 5% 3% 2% Shkilko et al Abnormality only observed at and inside the quotes Ly Tran Locks and Crosses 4/25

6 Locks & Crosses in Practice Observation of Abnormality Locks & Crosses by Different Views Contributions Security Exchange Commission Rule 4613 (2000): Nasdaq, trading hours Rule 610 (2007): prohibits locks & crosses Proponents: rules resolve issues of non-positive spreads Confusion and unfairness to market participants Slow trading: halt auto-execution, trigger manual execution Opponents: rules create unintended consequences Lack of transparency; breeding new order types Increase in high-frequency trading Ly Tran Locks and Crosses 5/25

7 Observation of Abnormality Locks & Crosses by Different Views Contributions Locks & Crosses in Academic Literature Nasdaq preopening: signals to price discovery Nasdaq & NYSE trading hours Friction among networks Maker-taker pricing Order-in-transit Ly Tran Locks and Crosses 6/25

8 Contributions Observation of Abnormality Locks & Crosses by Different Views Contributions Three hypotheses on locks and crosses Locks Crosses Information Market conditions Make-taker fees Implications Locks & crosses in unregulated market Limit-order books carry information Ly Tran Locks and Crosses 7/25

9 Outline Observation of Abnormality Locks & Crosses by Different Views Contributions 1 Observation of Abnormality Locks & Crosses by Different Views Contributions Ly Tran Locks and Crosses 8/25

10 Large High-Frequency Minute-by-minute February 28th - June 3rd, currencies vis-a-vis USD EUR, JPY, GBP, AUD, CHF, CAD, NZD Aggregated from 7 distinct ECNs Reuters, EBS, Hotspot, Lava, Currenex, FXCM, and espeed 16 series per currency Best bid, best offer Best marginal price at which one could buy or sell 5mn, 10mn, 20mn, 40mn, 80mn, 160mn, 320mn Ly Tran Locks and Crosses 9/25

11 Snapshot of Limit-Order Book EUR, Mar 03, 2008, 9:26 am Price Depth amount Bid Ask Mid-quote Total almost 1 million observations Ly Tran Locks and Crosses 10/25

12 Three Hypotheses Locks and crosses are created to convey information held by traders Market fragmentation hypothesis In fragmented market, market conditions affect locks and crosses occurrences Maker-taker pricing hypothesis Pricing schemes that favor liquidity makers over liquidity takers encourage locks and crosses occurrences Ly Tran Locks and Crosses 11/25

13 Information Hypothesis Hypothesis Locks and crosses are created to convey information held by traders Examine relationship Price movement during & after normal, lock, cross Locks & crosses: size, net depth Future price dynamics: returns, volatility Ly Tran Locks and Crosses 12/25

14 Intensity of Price Contribution Intuition Does price tend to move more during locks, crosses, or normal markets? Measure IPC c,mk t = m t Pm c,mk ( m t Pc m )( m t I c,mk m ) c Currency P Change in price m, t Time subscripts mk Market type lock, cross, normal I m k Index, = 1 if market is mk Ly Tran Locks and Crosses 13/25

15 Crosses Contribute More to Price Changes Findings Crosses contribute more than normal and locked markets Locks is not different from normal markets Literature Locks and crosses contribute more than normal markets Crosses contribute more than locks Lock/Norm Cross/Norm Total *** EUR *** JPY *** GBP *** AUD *** CHF ** CAD * NZD 1.34* 2.66*** Ly Tran Locks and Crosses 14/25

16 Net Depth Measures Order Imbalance Net depth = OverlapDepth bid - OverlapDepth ask Best bid Best ask OverlapDepth ask OverlapDepth bid Ly Tran Locks and Crosses 15/25

17 Cross Net Depth Predicts Future Returns In-sample predictive power for future returns rets c,mk m+t = α + βc,mk netdepm c,mk + ε c m Cross 10 b c,mk 95% CI Coefficients, units of min 1/2hour 1hour 1.5hour 2hour 3hour 6hour 9hour 12hour 1day Ly Tran Locks and Crosses 16/25

18 Lock Net Depth Not Associated with Returns Lock 8 b c,mk 95% CI 6 Coefficients, units of min 1/2hour 1hour 1.5hour 2hour 3hour 6hour 9hour 12hour 1day Non-significant coefficients Ly Tran Locks and Crosses 17/25

19 Cross Size Anticipates Volatility CrossSize = Spread Spread<0 vol c,t m+1 = φ + γt CrossSizem c + um c.3.25 Cross Size Coefficients g T 95% CI Coefficients /2hour 1hour 1.5hour 2hour 3hour 6hour 9hour 12hour 1day Ly Tran Locks and Crosses 18/25

20 Locks, Crosses, and Price Discovery Cross variables convey information Cross size Future volatility Cross net depth Future returns Consistent with information hypothesis Locks not associated with future price dynamics Does not support information hypothesis Ly Tran Locks and Crosses 19/25

21 Hypothesis Hypothesis In fragmented market, market conditions affect locks and crosses occurrences Conjecture for increases in probability of locks and crosses: High volatility & low depth at quotes Friction across networks Delayed quote updates Ly Tran Locks and Crosses 20/25

22 Results in More Locks & Crosses Market conditions associated with increasing probability Locks Crosses Narrow spreads High volatility Low depth at quotes Locks & crosses created due to market fragmentation Locks occur more consistently regardless of volatility & depth at quotes Ly Tran Locks and Crosses 21/25

23 Hypothesis Hypothesis Pricing schemes that favor liquidity makers over liquidity takers encourage locks and crosses occurrences What is it? Pricing scheme Equity exchanges often Rewards liquidity makers (e.g. 20 cents/100 shares) Penalizes liquidity takers (e.g. 30 cents/100 shares) Other approaches also available Foreign-exchange ECNs No liquidity rebates, but Some charge liquidity takers more than liquidity makers E.g.: 0.01bps/1$ (Hotspot) Ly Tran Locks and Crosses 22/25

24 Cross Size Exceeds Spread Basis points Ratio EUR JPY GBP AUD CHF CAD NZD Cross size Spread Cross size/spread 2 Maker-taker pricing only supports small cross size and locks Ly Tran Locks and Crosses 23/25

25 Results are Robust to Multiple Specifications Sub-segments of data Biweekly Monthly Half-period Volatility Calculated from 1-minute vs. 5-minute returns During high vs. low volatility periods Individual currency as well as panel data Locks include small cross sizes Ly Tran Locks and Crosses 24/25

26 Crosses contribute more to price changes Crosses have predictive power for future volatility and returns Market conditions in fragmented market Crosses associated with spread, volatility, and depth Locks associated with narrow spreads Locks could happen by chance Maker-taker pricing Locks, but not crosses Implications Limit-order book carries information Ly Tran Locks and Crosses 25/25