FIN11. Trading and Market Microstructure. Autumn 2017

Size: px

Start display at page:

Download "FIN11. Trading and Market Microstructure. Autumn 2017"

Gerald Fletcher
6 years ago
Views:

1 FIN11 Trading and Market Microstructure Autumn 2017 Lecturer: Klaus R. Schenk-Hoppé

2 Session 7 Dealers

3 Themes Dealers What & Why Market making Profits & Risks Wake-up video: Wall Street in 1920s feature=player_embedded&v=mbyvazwaq2m

4 Questions NYSE moved from twice-daily auctions to [...] trading in 1870s How? Why? How can one offer immediacy? Solution LOB Solution D

5 Dealers Make continuous markets Buy when others want to sell Sell when others want to buy Liquidity providers Profit-motivated traders Try to buy low & sell high

6 Dealers are passive traders high-frequency traders do not specialize in information gathering know little about fundamental values with whom they trade

7 Quote-driven dealer markets Dealer sells Public seller 10:00 10:10 Public buyer Dealer Buys 10:20 Dealers provide immediacy which indirectly brings buyers and sellers together

8 Dealers' business model Revenue generators Bid/ask spread (trading order flow) Commissions Cost generators Inventory cost carrying unbalanced inventory Information cost trading with better informed participants

9 Example: Quote-driven market

10 Option market example

11 The inside spread in a dealership market Best offer (Dave) Inside spread Denise Dan Dinah Derek Dave Best bid (Denise)

12 Fact Many market venues rely on dealers or specialists to improve market resilience NYSE has Designated Market Makers (formerly Specialists) NASDAQ has Dealers LSE has Market Makers

13 Stressful market conditions Bear markets Important news Derivatives expirations Momentum trading (e.g. stop orders) Daily openings Large orders (here dealers become block facilitators)

14 A Stressful Market Situation

15 Question Are dealers on the sell side or buy side?

16 Dealers vs brokers Dealers trade with their customers Brokers trade on behalf of their customers Dealers are principals Brokers are agents Suppose you want to buy an option contract Retail clients trade with a dealer through their broker Is there a potential problem?

17 What makes a good, i.e. profitable dealer?

18 What makes a profitable dealer? Inventory control Trading the order flow carefully Ability to hide/disguise large positions Knowledge of customers (source of the order flow) important in practice Receiving a large percentage of the order flow Customer relationships, Quote matching Preferencing Maker-taker pricing (exchanges aim to attract liq.)

19 Dealers' two main challenges How to handle inventory How to set the spread

20 Inventory management (FX) Source: Bjønnes & Rime, JFE (2005) Dealer behavior and trading systems in foreign exchange markets

21 Dealers' inventories Inventories: positions dealer has on the securities they trade Long/short positions possible Target inventory: position dealer wants to hold Dealer s inventory is in balance when it is near the dealer s target levels (out of balance otherwise)

22 Inventory control I n c r e a s e in v e n t o r y Inc re a s e p ric e s (b id & a s k ) Inc re a s e b id s iz e R e d u c e a s k s iz e T a k e oth e r de a le r's off e r D e c r e a s e in v e n to r y D e c re a s e pric e s (b id & a s k ) R e d uc e bid s iz e In c re a s e a s k s iz e H it othe r d e a le r's bid Alternative (if available): Hedge your position

23 Quotes and inventory positions

24 Inventory risk (unpleasant!) Diversifiable (no systematic loss) if future price changes independent of inventory imbalances deal in many instruments Adverse selection (systematic loss) if future price changes inversely related to inventory imbalances dealers trade with informed traders

25 Adverse selection risk Informed traders buy when they think that prices will rise sell when they think that prices will fall If dealer trades with informed trader prices tend to fall (rise) after dealer bought (sold) Prices tend to fall when dealer is long, and rise when short Realized spreads are often negative What can be done?

26 Dealer's response to adverse selection If you believe you just traded with informed trader Adjust prices and sizes to Discourage more trade in same direction Encourage trade in opposite direction Unload your unbalanced position on another dealer: 'Shares sold to a market maker are still for sale' Hedge your unbalanced position Whatever you do, it must be done quickly Ex ante, dealers set their bid/ask spreads to protect themselves against informed traders

27 Trading with dealers

28 Recap: Market maker services Immediacy Rapid execution of customer orders Supplemental liquidity But only temporary: Price discovery "Shares sold to a market maker are still for sale Market makers try to predict what sell side will do Price improvement, due to Customer relationship Inventory management Buy/sell pressure

29 Buy-side trading in dealer markets Directly with dealers Ask for two-sided quote before revealing whether you want to buy or sell. WHY? Through a broker Brokers know inside spread May obtain price improvement Brokers build reputations for not representing informed clients But we may not get best quoted bid or ask: due to preference arrangements between brokers and dealers Dealers pay for order flow

30 Question In FX (foreign exchange) markets why is/was there so much trade between dealers? Decentralized (in 1995, 85% was inter-dealer) Large sizes (distribution)

31 Bid/ask spread

32 Bid/ask spreads Spread = price of immediacy Market orders pay... to dealers and limit orders Most important factor in order placement decision (market vs limit orders) Most important factor in dealer s decision on liquidity provision

33 Dealer spreads Monopolistic dealer sets spread s.t. max volume(spread) x (spread-costs) But dealers face tough competition from other dealers limit order traders In competitive dealer market spread = cost cost = Transaction costs + Adverse selection costs

34 Spread/cost components Transaction cost component Running costs of doing business, risk premium, plus any monopoly profits Responsible for the bid-ask bounce Transitory spread component Adverse selection component Compensate dealers for losses to informed traders Permanent spread component

35 Adverse selection component of spread Customer asks dealer (you!) for a two-way quote You say: Bid 50,000@68.20, Offer 50,000@68.50 a)customer says: I buy 50,000 Do you learn anything? How much does the customer think the stock is worth? How did the customer arrive at her value estimate? Did you ask too little? b)customer says: I sell 50,000 Did you bid too much? When you make your (two-sided) quote, you must anticipate what you will learn about the market when the customer says buy or sell

36 Adverse selection & uninformed traders When uninformed traders use limit orders (a) If informed traders on same side price moves away from the uninformed trader no execution; regrets not trading (b) If informed traders on other side uninformed trader gets execution price moves against him; regrets trading When uninformed traders use market orders pay large spreads (due to informed trading)

37 2 views on adverse selection component Information perspective Difference in value estimates that dealers make conditional on the next trader being a buyer or a seller Accounting perspective Portion of spread that dealers must quote to recover from uninformed traders what they lose to informed traders

38 The enemy of liquidity Informed trading The more trades are informed, the more money you lose

39 Toxicity of order flow The PIN measure (technical) A highly simplified version of 1996 JF paper by Easley, Kiefer, O'Hara, Paperman Market maker posts bid B and ask A, B < A There are uninformed traders (your gain) and informed traders (your loss) Arrive with probabilities u and i News arrival: none, good, bad with prob 1-a, a/2, a/2 Price: today S(0) = S tomorrow S(1) = S, SG, or SB, with SG > S >SB

40 Problem: Set A and B Break even condition (perfect competition) Expected price tomorrow ES (1)=(1 a) S+0.5 a SG+0.5 a SB Expected profit from buying at bid B u [ ES (1) B ]+i [SB B ]=0 (gain) (loss) Selling at ask A u [ A ES (1)]+i [ A SG]=0

41 Calculate bid-ask spread Solve the two profit equations Calculate A B i A B= [SG SB] i+u The more likely arrival of informed traders, the wider the spread Estimate empirically to explain market under stress Volume matter as well VPIN

42 VPIN in practice Applied to 2010 flash crash and to study daily mini flash crashes Proposed to regulators and exchanges Toxicity of order flow But thorny estimation issues O'Hara is on CFTC-SEC Emerging Regulatory Issues Task Force (the flash crash committee)

43 Determinants of equilibrium spreads in continuous order-driven markets Information asymmetry among traders (+++) Volatility (++) Value of trader time (+) Trader risk aversion (+) Time to cancel limit orders (++) Limit order management costs (+) Differential commission between limit and market orders (++) Exchanges move to Maker-Taker model

44 Market making ETF (very fast growing segment) May 26, 2013 Bats Chi-X Europe plans to shake-up the ETF market (smart order routing) June 3, 2013 LSE hits back % of exchange-traded funds in EU - Registered ETF market makers: = 26 - fees reduced by 50% to 0.10bp

Economics of Market Making by Robert A. Schwartz and Bruce W. Weber Zicklin School of Business Baruch College, CUNY

Economics of Market Making by Robert A. Schwartz and Bruce W. Weber Zicklin School of Business Baruch College, CUNY Università degli Studi di Bergamo Corso di Laurea Specialistica in Ingegneria Gestionale