Solutions to End of Chapter and MiFID Questions. Chapter 1

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1 Solutions to End of Chapter and MiFID Questions Chapter 1 1. What is the NBBO (National Best Bid and Offer)? From 1978 onwards, it is obligatory for stock markets in the U.S. to coordinate the display of their data. This requirement by American authorities implied order books to be consolidated in real time and made public. The NBBO is mentioned for the first time in this binding regulatory framework. The Consolidated Quotation System (CQS) funded by FINRA (Financial Industry Regulatory Authority) operates this aggregation procedure and publishes continuously the highest and the lowest of all bids for all stocks traded in different exchanges. 2. Give the definition of a fragmented market. The term refers to the fragmentation of order flow, i.e. the ability to buy and sell shares of the same stock in different exchanges, centralized, MTF, or over-the-counter. In a fragmented market, a stock could be quoted and traded in more than one exchange. After November 2007, implementation of MiFID in Europe allowed different exchanges to operate in countries which previously had centralized national exchanges (like the one in France). This decentralization process stimulated competition and consequently increased fragmentation. 3. Give an example to a fragmented market. Stocks listed in Paris are traded on UTP (Universal Trading Platform) of NYSE- Euronext, but also traded on CHI-X, BATS ( now merged to BATS CHI-X Europe), NYSE-ARCA or SmartPool (two other trading platforms operated by NYSE- Euronext). 4. Give the definition of the following acronyms: MTF, ECN, ATS. MTF: Multilateral Trading Facility MTF is a specific type of European financial trading system introduced after MiFID. It refers to a trading venue that brings together buyers and sellers in a non-discretionary way according to a defined set of rules resulting in trades. ECN: Electronic Communications Network In the U.S. ECN refers to all trading venues which use automated quotation systems and which are not classified as a national market by the SEC. ATS: Alternative Trading System It is the equivalent of MTF in the U.S. It includes ECNs but also crossing networks and darkpools where prices are imported. 5. The New York Stock Exchange (NYSE) was one of the first automated markets: True or false? False. NYSE was one of the latest exchanges to become automatized. NYSE Hybrid has been put in place in Information technology (IT) has long been used at NYSE before that date, but mostly for post-market and order routing purposes.

2 6. Give the definition of inverted pricing (on trading venues). Transaction costs become negative under certain conditions. The broker or trading platform can pay for the flow of orders in order to gain market share. Ex. CHI-X that makes a discount for orders from liquidity providers (jump balls). 7. Does a trading venue necessarily determine trading prices through the matching of supply and demand? No. Some trading venues like crossing networks or darkpools import prices that have been determined in other markets. 8. What is a dark pool? A trading venue where little or no information about transactions and order books is disclosed. In a dark pool, buyers and sellers are automatically matched without disclosing information about prices, quantity or the identity of buyers and sellers. Recently, smaller and smaller trades are being allowed through dark pools, resulting in increased liquidity. These platforms existed in LSE or Paris for block trades since 1980s. Although the intention was not to hide the identities of block traders originally, the size of the order practically caused a delay between the actual time of the transaction and the time it was made publicly available. 9. Prior to November 2007 (and MiFID), the French stock market was fragmented: True or false? True. Since 1994, there was a market for block trading which worked parallel with the central market. Large transactions were also executed in OTC (over-the-counter) markets. Determination of price outside the central market (which is similar to crossing) was carried out for much longer. 10. A single concentrated market is both more efficient and less costly: True or false? By definition, this is a monopoly which is often characterized by cost inefficiencies and resistance to change. To give an example, Euronext's income arising from transaction fees from multiple exchanges in 2005 (before its merger with NYSE) was higher than that of NYSE (concentrated market) while the transaction volume was 4.8 times larger in NYSE. 11. At the beginning of the 70's the NYSE was the dominant market in the US. The reason for this dominance is that all trades had to be conducted on it. True or false? False. Such a rule was never in force in the United States. This dominance is due to economies of scale related to the size and anticompetitive practices (due to regulatory capture) that wiped out potential competitors.

3 Chapter 2 1. What is the meaning of the following aconyms: CAC? NSC? CAC: Cotation Assistée en Continu: Continuous automated trading system. UTP: Universal Trading Platform. It is the unified platform (for all markets and all products) of NYSE Euronext. 2. Were forward trades allowed in Paris in the 19th century? They were not banned in the 19 th century. However, there was a legal uncertainty about how the contracts should be honoured. Parties related with the forward contracts often resulted in the courts and the court rulings were at times in favour of the defaulting party who walked out without paying the associated losses caused by his/her misconduct. In 1885, forward contracts became officially accepted (by law) and that type of legal uncertainty disappearead. 3. What does fixing mean? Is the term fixing used in French Stock Exchange derived literally from this meaning? What is the term used in Anglo-Saxon markets for fixing? Fixing in financial context refers to an administered or regulated price in English. The term fixing in the French sense is only used on the London Bullion Market for the gold market. In London Stock Exchange, the terms used are call auction (collection of unfilled orders) and auction matching (matching orders). 4. Define and contrast the following terms: broker, dealer, market maker. Broker: executes a transaction for a customer not on her own account. Dealer: can trade on her own account. Market maker: has her own account similar to a dealer, but has a specific objective of providing liquidity to the market. Contractually, the MM should be ready to disclose and provide the bid ask prices even for small quantities. 5. Do stocks trade continuously on a call-auction market? No. After collecting orders, stocks trade at a single point in time. 6. Do traders exactly know ahead of time when a fixing is to occur? No. For example, in London (SETS) or Frankfurt (XETRA), call auction is triggered randomly within a range of time is known. The goal is to thwart attempts to manipulation, but also to reduce the heavy traffic of orders concentrated at the moment of fixing. Also, a stock (or the whole stock market) can be suspended from trading at any point in time and the trading resumes after a call auction takes place. 7. How many times CAC40 constituent-stocks are traded through a fixing on a given trading day? Two as of 2011.

4 8. Under certain circumstances, stocks trading on the Paris stock exchange may be subject to reservation. Does this imply that trading on this stock is suspended? Yes. And the trading resumes with a call auction. 9. Give the definition of a quote-driven market. They are dealer based markets where dealers display the price ranges (bid and ask) they are willing to trade. Competition among dealers (usually) keep spreads low. Investors choose among dealers. The market is necessarily fragmented. Negotiations can occur, the traded prices can end up within the range displayed which constitutes the basis for negotiation. 10. Is it necessary to use ISP services to trade a stock on the Paris stock exchange? Yes, either directly via ISP members, or indirectly via e-brokers, banks. 11. A quote-driven market is necessarily a continuous market. True or false? True. 12. A limit order can trade at a better price than its limit price: True or false? True. 13. Can the tick size be lower than 1 cent? Yes. It is the total amount of the invoice, which is rounded to the nearest cent as in all commercial transactions. 14. What is the interpretation for the following limit order: buy at 95 Purchase with a reserve price of 95. The buyer knows that she will not pay more than 95 Euros per share. However, this order is incomplete, it should add the reference stock as well as the quantity and duration of validity of the order (in most exchanges a default validity is used). 15. Give the definition of a good-till-cancelled order. An order which is valid for the exchange defined duration (1 year on Euronext) unless cancelled. 16. Suppose that an order is modified on UTP. Is its time priority reset? Yes, the time priority is set with respect to the moment when the order is made public (displayed). If one of the characteristics of the order changes, the time priority is reset.

5 17. What is the size of trading lots in Paris? One. In New York it is 100. If you want to trade shares between 1-99, you have to put an odd-lot order in fractions. 18. Suppose you trade using the SRD facility. Do you trade at the spot price or at the forward price? Before 2000, it was forward, since September 2000 this is a spot. This change was in particular to align Paris Stock Exchange with the Anglo-Saxon markets. The Deferred Settlement Service (SRD in French) is a mechanism that allows French investors to take a long or short leveraged position. The service is mainly used by private investors as an alternative to margin accounts. See for a detailed functioning of SRD facility. Currently, the SRD mechanism only exists in the French market, although NYSE Euronext is working with regulators to expand it to other Euronext countries. Chapter 3 1. The effective spread can only be measured when a trade occurs: true or false? Yes, this is by definition. See Section 3.3, p Can a trade have a sign (buy trade or sell trade)? Yes, the reference is made to the side which causes the transaction, that is to say which is the initiator of the transaction. Buyer-initiated trades have positive signs whereas seller-initiated trades have negative signs. 3. Explain why the spread is related to asymmetric information. Assume a dealer-based market where the dealer does not have private information about the expected move in the price of the stock. His job is to show a range of prices, how will he determine the prices? He knows that some investors have information that he does not possess and he will lose out if he trades with them. The range of prices will be a little higher than it would be in the absence of better informed investors. The difference will be established so that the expected gains he will make on each transaction, just equal to the expected losses he will make with better-informed investors (but not identified a priori). 4. Who takes advantage of a large tick size? Those for whom a visible and high level of depth is important. Probably some institutional investors.

6 5. What is the evolution of market depth over recent years? Larger? Smaller? Why? Market depth reduced significantly in recent years. The reason is largely due to reduction in tick sizes. When tick sizes were large, investors had incentives to position their orders so that they could take advantage of time priority, which resulted in accumulation of orders at best bid and asks, thus higher depth. Reducing tick sizes resulted in time priority being less important, because investors could now go ahead of other orders by placing their orders at a higher ask or bid with a marginally lower cost. Also, automation of executions in recent years (smart order routing technology) enabled routing of orders and executing them while minimizing their visibility. But great market depth is not necessarily synonymous with high liquidity, because you have many orders in the first couple of price ranges and not so many in others. 6. In your opinion, is it better to use time priority instead of price priority as the first priority? Yes, as explained above if tick size is large time priority becomes important. 7. To what extent does the synthetic liquidity measure computed by the Frankfurt stock exchange (Xetra liquidity measure) capture the price impact of an order? Fictitious orders are introduced in the book (ex post, not in real time), so as to compare pricing systems with (fictitious orders) and without (what really happened) the fictitious orders. The impact of fictitious orders is measured by comparing the two sets of prices obtained and then stocks are classified according to the liquidity measure implied by this difference. MiFID Questions 1. Is MiFID responsible for the end of orders concentrating on a single market in the UK? No, actually, there was never such an obligation in the UK. 2. Can LSE members trade over-the-counter a stock that officially trades on the LSE? Yes. OTC market has almost the same trading volume with the shares traded on SETS. 3. A block trade is a large trade: true or false? Yes, but not only. It is a pre-arranged transaction. That is to say, a transaction in which an intermediary is involved "in facilitating the trade." On the other hand, all large transactions on NSC are not blocks necessarily. 4. In a regulated market (e.g. Euronext) all orders are displayed. True or false? Yes. Except stop orders and iceberg orders.

7 5. An MTF can list stocks. True or false? True. For example AlterNext on Euronext. 6. Dark pools invented opacity in trading. True or false? To what extent were block markets transparent prior to MiFID? False. Opacity has always been the case in OTC (over-the-counter) markets. LSE and Paris previously allowed block trading where quantities and prices could be disclosed after two days. 7. Is the market transparent for the investor whose order trades using the Euronext "internal matching service"? No. For example, members are not obliged to inform their clients whether their trades have been executed or not. Normally, transactions should be reported to the central market, however such a report is not prepared by internal matching service. Exercise 1.1 Competition Does having a large number of market makers who compete for order flow ensure the lowest possible trading costs? Christie and Schultz (1994) showed that collusion among market makers on the NASDAQ, the second largest U.S. equity market, artificially increased transaction costs, even though, for example for Microsoft stock 35 of dealers were apparently in competition. At the time the study was published, bid or ask quotes in Nasdaq were multiples of an eighth of a dollar for bid prices exceeding $10. So normally you would expect spreads to be 1/8 of a dollar, i.e cents. They found that even tick sizes ranges corresponding to 2/8 th, 4/8 th and 6/8 th of a dollar, i.e. spreads of 0.25, 0.50 or 0.75, were much more common than odd tick size ranges, i.e. spreads of 0.125, 0.375, The range displayed was artificially marked up compared to what would have been in an effective competition. The findings of this study have been published by American press on 26 and 27 May 1994 and the following Monday, transaction costs (estimated by the spread) have been magically reduced by more than 40% and were further reduced since. Various other surveys have confirmed the results of Christie and Schultz and led to a reorganization of NASDAQ. The profession had to spend a billion dollars in compensation for collective actions (class actions) brought by shareholders. NASDAQ had to invest billions more in order to modernize the way it was organized and especially open its order book to competition after In April 2005, NASDAQ announced its proposed acquisition of INET Reuters (which itself resulted from the merger of Instinet (inventor of crossing networks) and Island (electronic trading platform with a large order book) announcing new changes and a greater emphasis on electronic markets.

8 Exercise 1-4: Crossing, competition and market quality Markets relying on crossing match buyers and sellers at a price imported from a regular market and use this public good (which is free) to organize trades and make profits. How can regular markets cope with this competition? By regulation. You can get monopoly power which was the case in France before By reducing the spread, improving liquidity and reducing transaction costs. This implies that the quantities available at the best limits (depth) are large enough to satisfy institutional investors. By creating a dual market. Alongside operating a traditional market with wide enough price ranges and spreads for individual investors, operating a crossing market reserved for institutional investors, like Xetra Block Crossing. By disclosing noisy prices. This has been practiced by some specialists at NYSE until 1993.

Market Fragmentation: Does It Really Matter?

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