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2008, 45
Central counterparties (CCPs) have increasingly become a cornerstone of financial markets infrastructure. We present a model where trades are time-critical, liquidity is limited and there is limited enforcement of trades. We show a CCP novating trades implements efficient trading behaviour. It is optimal for the CCP to face default losses to achieve the efficient level of trade. To cover these losses, the CCP optimally uses margin calls, and, as the default problem becomes more severe, also requires default funds and then imposes position limits.
2008, 44
n the last few years, many of the world’s largest financial exchanges have converted from mutual, not-for-profit organizations to publicly-traded, for-profit firms. In most cases, these exchanges have substantial responsibilities with respect to enforcing various regulations that protect investors from dishonest agents. We examine how the incentives to enforce such regulations change as an exchange converts from mutual to for-profit status. In contrast to oft-stated concerns, we find that, in many circumstances, an exchange that maximizes shareholder (rather than member) income has a greater incentive to aggressively enforce these types of regulations.
2008, 43
The execution, clearing, and settlement of financial transactions are all subject to substantial scale and scope economies which make each of these complementary functions a natural monopoly. Integration of trade, execution, and settlement in an exchange improves efficiency by economizing on transactions costs. When scope economies in clearing are more extensive than those in execution, integration is more costly, and efficient organization involves a trade-off of scope economies and transactions costs. A properly organized clearing cooperative can eliminate double marginalization problems and exploit scope economies, but can result in opportunism and underinvestment. Moreover, a clearing cooperative may exercise market power. Vertical integration and tying can foreclose entry, but foreclosure can be efficient because market power rents attract excessive entry. Integration of trading and post-trade services is the modal form of organization in financial markets, which is consistent with the hypothesis that transactional efficiencies explain organizational arrangements in these markets.
2008, 46
This paper considers a trading game in which sequentially arriving liquidity traders either opt for a market order or for a limit order. One class of traders is considered to have an extended trading horizon, implying their impatience is linked to their trading orientation. More specifically, sellers are considered to have a trading horizon of two periods, whereas buyers only have a single-period trading scope (the extended buyer-horizon case is completely symmetric). Clearly, as the life span of their submitted limit orders is longer, this setting implies sellers are granted a natural advantage in supplying liquidity. This benefit is hampered, however, by the direct competition arising between consecutively arriving sellers. Closed-form characterizations for the order submission strategies are obtained when solving for the equilibrium of this dynamic game. These allow to examine how these forces affect traders´ order placement decisions. Further, the analysis yields insight into the dynamic process of price formation and into the market clearing process of a non-intermediated, order driven market.
2008, 42
Central counterparties
(2008)
Central counterparties (CCPs) have increasingly become a cornerstone of financial markets infrastructure. We present a model where trades are time-critical, liquidity is limited and there is limited enforcement of trades. We show a CCP novating trades implements efficient trading behaviour. It is optimal for the CCP to face default losses to achieve the efficient level of trade. To cover these losses, the CCP optimally uses margin calls, and, as the default problem becomes more severe, also requires default funds and then imposes position limits.
2008, 41
Algorithmic trading has sharply increased over the past decade. Equity market liquidity has improved as well. Are the two trends related? For a recent five-year panel of New York Stock Exchange (NYSE) stocks, we use a normalized measure of electronic message traffic (order submissions, cancellations, and executions) as a proxy for algorithmic trading, and we trace the associations between liquidity and message traffic. Based on within-stock variation, we find that algorithmic trading and liquidity are positively related. To sort out causality, we use the start of autoquoting on the NYSE as an exogenous instrument for algorithmic trading. Previously, specialists were responsible for manually disseminating the inside quote. As stocks were phased in gradually during early 2003, the manual quote was replaced by a new automated quote whenever there was a change to the NYSE limit order book. This market structure change provides quicker feedback to traders and algorithms and results in more message traffic. For large-cap stocks in particular, quoted and effective spreads narrow under autoquote and adverse selection declines, indicating that algorithmic trading does causally improve liquidity.
2008, 39
We consider a multi-period rational expectations model in which risk-averse investors differ in their information on past transaction prices (the ticker). Some investors (insiders) observe prices in real-time whereas other investors (outsiders) observe prices with a delay. As prices are informative about the asset payoff, insiders get a strictly larger expected utility than outsiders. Yet, information acquisition by one investor exerts a negative externality on other investors. Thus, investors’ average welfare is maximal when access to price information is rationed. We show that a market for price information can implement the fraction of insiders that maximizes investors’ average welfare. This market features a high price to curb excessive acquisition of ticker information. We also show that informational efficiency is greater when the dissemination of ticker information is broader and more timely.
2008, 40
We find and describe four futures markets where the bid-ask spread is bid down to the fixed price tick size practically all the time, and which match counterparties using a pro-rata rule. These four markets´ offered depths at the quotes on average exceed mean market order size by two orders of magnitude, and their order cancellation rates (the probability of any given offered lot being cancelled) are significantly over 96 per cent. We develop a simple theoretical model to ex- plain these facts, where strategic complementarities in the choice of limit order size cause traders to risk overtrading by submitting over-sized limit orders, most of which they expect to cancel.
2008, 53
This paper analyzes liquidity in an order driven market. We only investigate the best limits in the limit order book, but also take into account the book behind these inside prices. When subsequent prices are close to the best ones and depth at them is substantial, larger orders can be executed without an extensive price impact and without deterring liquidity. We develop and estimate several econometric models, based on depth and prices in the book, as well as on the slopes of the limit order book. The dynamics of different dimensions of liquidity are analyzed: prices, depth at and beyond the best prices, as well as resiliency, i.e. how fast the different liquidity measures recover after a liquidity shock. Our results show a somewhat less favorable image of liquidity than often found in the literature. After a liquidity shock (in the spread or depth or in the book beyond the best limits), several dimension of liquidity deteriorate at the same time. Not only does the inside spread increase, and depth at the best prices decrease, also the difference between subsequent bid and ask prices may become larger and depth provided at them decreases. The impacts are both econometrically and economically significant. Also, our findings point to an interaction between different measures of liquidity, between liquidity at the best prices and beyond in the book, and between ask and bid side of the market.
2008, 52
Previous evidence suggests that less liquid stocks entail higher average returns. Using NYSE data, we present evidence that both the sensitivity of returns to liquidity and liquidity premia have significantly declined over the past four decades to levels that we cannot statistically distinguish from zero. Furthermore, the profitability of trading strategies based on buying illiquid stocks and selling illiquid stocks has declined over the past four decades, rendering such strategies virtually unprofitable. Our results are robust to several conventional liquidity measures related to volume. When using liquidity measure that is not related to volume, we find just weak evidence of a liquidity premium even in the early periods of our sample. The gradual introduction and proliferation of index funds and exchange traded funds is a possible explanation for these results.