Final

Question 1

Value of a stock

Answer 1

Present value of all expected future distributions of money to the shareholder

Question 2

Two core features of the stock market

Answer 2

As an information market; the stock market is pervasively a creature of the law/regulation

Question 3

Dealer market

Answer 3

Dealers determine quotes on which others can transact with

Question 4

Pros and Cons of Multi-venue system

Answer 4

Pros: Greater efficiency and higher rate of innovation arising from competition Cons: Fragmented orders, less likely that buyers and sellers find one another

Question 5

Stock exchange

Answer 5

A market for bringing together purchasers and sellers according to establish rules, that chooses to register as an SRO

Question 6

Alternative Trading System

Answer 6

Exchange like venue that chooses not to register as an exchange

Question 7

Non-ATS Off-Exchange Trades

Answer 7

BD either satisfies incoming customer orders directly from its own inventory of stocks or sells its customers order flow to another BD that acts directly as a counterparty to the flow of retail buy and sell orders that it purchases

Question 8

Why is profitable to internalize/pay for order flow?

Answer 8

Likely transacting against uninformed retail orders, not facing adverse selection

Question 9

Market Order

Answer 9

An unconditional instruction to trade at the best price available

Question 10

Limit order

Answer 10

A conditional order to buy/sell a specified number of shares at a specified price

Question 11

The cost of liquidity

Answer 11

The bid-ask spread; the larger the spread, the more expensive it is to transact. Larger spread means that the price you pay will be further away from the fair market value of the stock

Question 12

Fair market value of a stock

Answer 12

Assumed to be the mid point of the bid-ask spread

Question 13

Intermarket Sweep Order

Answer 13

+ limit orders are routed to execute against the full displayed size of any protected bid or protected offer for the NMS stock with a price superior to the limit price of the limit order identified as an ISO. Once those protected quotes are taken out, drill through the order book at the trading center until your limit price is reached; ISO allows the targeted exchange to almost instantaneously process the order; an ideal order type if you are looking for speed and large volume to preserve some informational advantage

Question 14

Priority order

Answer 14

(1) best price (2) displayed (v. nondisplayed) (3) first to arrive; no time priority across exchanges

Question 15

Two central characteristics of market quality

Answer 15

Price accuracy: Accuracy with which the market price of an issuer’s shares predicts the issuer’s future cash flows. Liquidity: The costs of transacting relating to the size of a trade, the price, and the time it takes to accomplish the trade

Question 16

How does price accuracy generate social value

Answer 16

Use of existing productive capacity, effect allocation of capital. Guides real decision making. More accurate prices = higher likelihood that prices reflect managerial skill/problems, provide guidance to managers on the effects of decisions

Question 17

How does liqudity generate social value

Answer 17

Allocation of resources of time (consumption today v. future consumption), risk allocation (diversification). Liquidity also promotes the generation of more fundamental value information

Question 18

Use of Knowledge in Society

Answer 18

Advantage of the market is that it is a decentralized organization, allowing for decentralized decision makers to use their local and specified knowledge, with the resulting price incoporating all of this decentralized information

Question 19

Efficient market hypothesis

Answer 19

Theorizes that securities prices at any time fully reflect all public information relevant to its value

Question 20

Best reflection of the quality of a company

Answer 20

Marekt capitalization (# of shares x value of shares), EMH says that price of good companies should be competed to its accurate price, so should not expect trading profits

Question 21

FPE v. RPE

Answer 21

You can have forecasting price efficiency (meaning that future cash flows are accurately forecasted) but lack revelatory price efficiency (meaning that the price does not reveal all information that would affect a real decision maker

Question 22

Informed Traders

Answer 22

Trade on the basis of private info or analysis enabling them to have a more accurate view of the value of a companies stock than the current price of that stock

Question 23

Uninformed traders

Answer 23

Buy/sell shares without possession of info that allows for a more accurate appraisal of the stock’s value than the current marekt price

Question 24

Liquidity Providers

Answer 24

Engage in the frequent posting of nonmarketable limit orders with which others can interact. Make a business out of facilitating trades

Question 25

Adverse Selection

Answer 25

LPs lose money (on average) to trades with informed traders and reflect that cost through widened bid ask spread; the higher level of informed traders faced by LPs, the less liquid the market (larger bid-ask spread). Policy tradeoff is desire for a liquid market (which is maximized in an environment with low adverse selectioN) but we also want an informed market because that leads to more accurate prices

Question 26

Accounting perspective

Answer 26

For an LP to make money, it must offset what is loses by trading with informed traders by what it gains from trading with uninformed traders

Question 27

Information perspective

Answer 27

For a LP to make money, it must update its estimate of a stock’s value depending on whether the next order that transacts against its quotes is a buy or sell – resulting in a larger bid-ask spread. Incoming orders have informational value about the type of order it is

Question 28

CLOB

Answer 28

A single venue where all marketable orders could interact with a centralized book of quotes. Benefits: Maximize competition among orders, public and regulatory scrutiny is focused, maximize liquidity, fewer resources used. Drawbacks: How do we ensure it doesn’t charge high prices and fail to innovate? Lack of competition on fees and innovation, problems that come with regulating a public utility, would elimiinate anticipatory order cancellation

Question 29

Interlinked Market System

Answer 29

Idea was to link all venues to promote competition and innovation. Upside is that it encourages competition among orders, fewer regulaotry costs than overseeing a CLOB, more likely to spur innovation. Drawbacks: Reduces execution speed and quality, increases technology costs, improved quote transparency may not eliminate the power of exchanges

Question 30

Registered Exchanges

Answer 30

Self-regulatory responsibility, highly automated trading systems, offer proprietary data feeds, collocation services

Question 31

Dark Pools

Answer 31

Dark liquidity, can restrict who has access, regulated as ATS and registered as BDs. Offer trading services to institutional investors and others seeking to trade large block trades that will minimize movement of prices against the trading interest, thereby reducing trading costs

Question 32

601

Answer 32

Trade Dissemination: All trades must be reported subject to a transaction reporting plan. Exchanges report directly to SIPs. TRF is created for brokers to report off exchange trades

Question 33

602

Answer 33

Quote dissemination: Requires exchange members and OTC market makers exceeding 1% of trading volume to provide their best priced quotes to their respective exchanges or FINRA; Best bid, offer, and aggregate quotation size at those prices for each publicly listed stock. ECNs publish actionable orders.

Question 34

603

Answer 34

Equal access: Distribution of information on fair and reasonable terms – not unreasonably discriminatory. SIPS display NBBO and trades through a single processor

Question 35

604

Answer 35

Requires exchange specialists and OTC market makers to display certain customer limit orders in their best-priced quotations provided under 602. Exceptions for internalized, odd lots or block sized orders. Orders that represent an improvement on the best price, or are equal to the best price and represent more than a minimal change in depth

Question 36

605

Answer 36

Order execution quality

Question 37

606

Answer 37

Order Routing

Question 38

607

Answer 38

Customer Accounts

Question 39

610

Answer 39

Equal access to quotations: Exchanges must offer all customers the same rate schedule and access to trades. Access fees limited to $.003. Exchanges should stop locked and crossed markets from happening and have policies to unlock them if they do. Necessitated by trade through rule

Question 40

611

Answer 40

• 611: Order protection rule: Can’t route so you trade at prices worse than SIP NBBO. This applies to all trading centers so it includes off-exchange trades. Trade-through is banned (with exceptions), meaning that quotes displayed at a trading center won’t be bypassed by trades with inferior prices at any other trading center
o Only the best displayed bid and offer at each trading center are protected
o Rule requires all trading centers to have polices and procedures reasonably designed to prevent trade-throughs of protected quotations
o The access cap (610) prevents a venue from undercutting the trade-through objective because otherwise a venue could attract transactions with better priced quotes and then charge high fees to access those quotes; an access cap becomes necessary when you require the trade through rule.
o Trade through rule is a backstop to overcome agency problems and ensure best-execution by broker-dealers (at least with regard to price)

Question 41

612

Answer 41

• 612: Minimum pricing increment: Tick size of $.01, nondisplayed quotes can be priced in increments less than pennies
o Decimalization improves price accuracy, informational value of the price, but decreases the depth of book by permitting more differentiation in quotes
o Larger tick size results in more depth and provides a built-in profit margin for LPS
o Current tick size could still be too big and give LPs and unnecessary profit margin (think: odd-eights scandal and decimalization); penny tick size is still concealing some information about the price

Question 42

Anticipatory Order Cancellation

Answer 42

An HFT, before others in the market, learns of a trade that occurred at one exchange and infers that similar orders may still be transit to other exchanges. After learning that info, it adjusts or cancels its quotes on other exchanges before those other orders arrive; • Positive Impact on Liquidity: Narrows spreads because it allows HFT to detect informed traders and avoid adverse selection
• Maybe Negative Impact on Price Accuracy: Informed traders (especially announcement traders) place fewer trades; any reduction is very slight. THis affects announcement and insider traders more, imporved price accuracy on a small time-horizon
• Tentative conclusion is that it increases social welfare because it enhances efficiency. BUT need to know more (if it increases or decreases large, uninformed trading; proportion of each type of informed trading; competitiveness of market; etc.).

Question 43

Slow Market Arbitrage

Answer 43

• HFT has the NBB or NBO, then detects a new NBB or NBO. Before the new NBB/NBO is shown in the public data stream, someone transacts with the HFT at its “stale” NBB/NBO. It then immediately transacts with the new NBB/NBO before anyone else can. HFT makes a profit b/c it first acquires stock at one price and then immediately unloads that stock at a better price
• Negative Impact on Liquidity: Increases cost of trading which disincentives production of price-enhancing information. As a consequence, negative effects on efficient allocation of resources over time and the efficient allocation of risk; Stops the HFTs from posting other bids/ask, decreasing liquidity and raising the cost of trading
• Potentially Negative Impact on Price Accuracy: Disincentivizes informed FVT because of increased trading costs, FVT improve price accuracy. Results in a negative effect on allocation of capital and efficient utilization of existing productive capacity

Question 44

Dark Pool Midpoint Order Exploitation

Answer 44

HFTs profit by taking advantage of stale DP MPOs. •
Potentially Positive Impact on Liquidity: Practice pushes uninformed traders to the exchanges which causes spreads to become narrower as LPs are subject to less adverse selection. However, increases the effect cost of trading for uninformed traders using dark pools
• Potentially Positive Impact on Price Accuracy: Increased cost of trading in DP send more uninformed traders to exchanges, results in narrower spreads, decreasing trading costs for FVTs who increase price accuracy

Question 45

Fundamental Value Trading

Answer 45

Gathering bits of publicly available info and observations, analyzing info in a sophisticated way that allows for a superior assessment of those cash flows than what is implied by current market pricing, and trading on that info
• Negative Impact on Liquidity: LPs are worse off by about an equal amount that the informed traders gain, increases the bid ask spread, making trading costlier for all. However, uninformed traders in the aggregate are not affected (those trading in the same direction as the informed trader are hurt, but those trading in the opposite direction are helped). Spreads widen, but share prices are discounted to reflect the widened spread.
o reducing social welfare because of the resulting misallocation of resources over time and of risk
• Positive Impact on Price Accuracy: Improves price accuracy. Prospect of trading profits generates incentive to gather useful information, create new information that might not otherwise exist. Price accuracy is improved sooner and over a longer span of time than with other forms of informed trading.
• makes prices more accurate way sooner than they otherwise would be which outweighs the costs to liquidity!

Question 46

Announcement Informed Trading

Answer 46

• Obtaining announcement info that has direct implications for the issuer’s future cash flows and trading on it before anyone else.
Negative Impact on Liquidity: LPs lose on trades with announcement traders by being adversely selected. LPs thus widen the bid-ask spread, making trade more costly for all; Reduces social welfare due to the resulting misallocation of resources over time and risk
• Slightest Positive Impact on Price Accuracy: Improvement of the share price accuracy is only for microseconds, information would be reflected in price very quickly even without such trading. Not even close to the amount of time required to result in better capital allocation and better utilization of the economy’s existing productive capacity, nobody makes decisions in this timeframe.
• This practice is socially undesirable because its capacity to augment the speed with which market prices reflect already existing information is of socially insignificant benefit in comparison to its downsides

Question 47

Classical Insider Trading/Issuer Inside Information

Answer 47

Information not yet publicly available that is obtained from within an issuer and that is relevant to predicting the future cash flows paid to shareholders
• Negative Impact on Liquidity: LPs face adverse selection, so they react by increasing the bid-ask spread, increasing cost of transacting, resulting in in reduced social welfare via misallocation of resources over time and of risk
• Slightest Positive Impact on Price Accuracy: Same as with announcement trading
• Undesirable whether or not the issuer consents, but only if info is material → Hurts liquidity, disincentivizes fundamental value trading, erodes public confidence in markets (even though it’s not actually unfair)
o BUT insider trading on small bits of nonmaterial, nonpublic info is beneficial because it would take a long time for the info to otherwise be reflected in price!

Question 48

Insider Information: Non-Issuer Source

Answer 48

trade based on confidential info obtained from institution other than issuer (e.g. agent of issuer—law firm, investment bank, etc.)
• Same wealth and efficiency effects as inside information from within the issuer
• but there are some kinds of trades based on info generated from non-issuer institution that is socially desirable b/c generation of new info will not occur unless institution allowed to trade on it—similar to FVT if developed on its own

Question 49

Market Based approach to reasonableness of proposes fees for prop data

Answer 49

o Was SRO subject to competitive forces in setting terms of proposal?
 Reasonable substitutes for the product/services
• When you charge more, do fewer people buy it…elasticity
• If demand is inelastic, probably no competitive subtitute
o Does latform competition constrain the fee?
 Two sided platform…we have to charge a lot for our product because our platform has another product that is cheaper
 So our net costs are reasonable
 Rauterberg is skeptical of this theory
 Platform theory is a good way to think about FB, Google, but not the exchange
o Revenue/cost evidence suggests minimal profits
 Evidence of cost to produce and how much we are making from that
o If not, much show substantial basis
 And even if so, is there a substantial countervailing basis?
• If not these reasons, must have some really justifiable reason for charging the fee
• Much of the brunt of the analysis falls on the competitive forces analysis
• Even if there is a reasonable purpose for the fee, the SEC can then reject proposal if they have a countervailing reason

Question 50

Conflict of interest for exchanges with SIP

Answer 50

 They have a vested interest in core data being slow and crappy…makes their prop data more valuable

Question 51

Market Data Infrastructure proposal

Answer 51

replace the exclusive SIP model with a decentralized model of competing consolidators that would collect, consolidate, and disseminate certain NMS information
Further depth of book information…the 5 prices lower than the protected bid and the 5 prices higher than the protected offer
o The Infrastructure Proposal would establish for the first time in Regulation NMS a definition of a “round lot,” changing the traditional 100-share concept of a round lot by assigning different round lot sizes to individual NMS stocks based upon their average closing price on the listing exchange over the prior month
o Under the Infrastructure Proposal, for a given NMS stock there could now be a separate and distinct NBBO and PBBO, with the NBBO potentially being better priced while not being protected under the OPR if it represents an order of less than 100 shares. Only protected if more than 100 shares
• This is a kind of half-way measure, not quite enough to displace the necessity of the proprietary data feeds for the market’s most active participants

Question 52

Option

Answer 52

A contract to buy or sell an underlying asset or security at a specified price on or before a given date; the right, but not the obligation, to buy or sell a specific asset for a specific price
Options market goes from a single exchange to looking something like the equity market, which has inreased competition, with advantageous results for customers

Question 53

Future

Answer 53

A standarized, liquidized, highly traded contract to transfer an asset at a specified date and price

Question 54

Why are equities and options markets different from the futures market?

Answer 54

o Futures exchanges have control over clearing services, which impedes competition as each future is generally limited to trading on only one exchange

Question 55

The Classical Theory of Insider Trading (Mandatory Rule)

Answer 55

• Trading on the basis of material non-public information (MNPI) procured in violation of a relationship of trust and confidence (RETAC) - a violation of 10b-5
o Insiders of the issuing company trading in the securities of the issuing company
o Chiarella first case to accept classical theory; says that duty to disclose under 10(b) does not arise from mere possession of non-public info

Question 56

Misappropriation Theory (Default Rule)

Answer 56

• trading by someone not in relationship of trust & confidence to counterparty violates 10b-5 if trading on material nonpublic info (MNPI) that has been misappropriated; Chiarella would be guilty under this theory
o Trading on MNPI in violation of a fiduciary duty owed to the (non-issuer) source of information
Trading on MNPI originating from an institution other than the issuer with permission is not a violation of 10b-5

Question 57

Tipper/Tippee Liability (classical)

Answer 57

• Tippee’s trade based on a tip from an insider within an issuer is prohibited only if the tipper received a personal benefit and tippee knew of the breach of RETAC by the tipper and that the tipper benefitted.
o Powell concerned w/ chilling analyst interviews, which are socially beneficial—w/o personal benefit, parties could violate 10b-5 when mistaking MNPI as public
o It is useful for execs and officers to talk to others about their company, but sometimes they disclose MNPI on accident
 Avoiding chilling analyst interviews allows analysts to gather and analyze pieces of immaterial nonpublic information that they can use to develop, and trade on, a superior analysis of the value of the issuer’s shares.

Question 58

Misappropriation tipping/tippee liability

Answer 58

• Breach of relationship of confidence and trust to the non-issuer source of MNPI
o Circuit courts are split on the issue
 If you agree with the logic of Dirks, which is to avoid chilling analyst interviews, then we should not have public benefits test here because there are no analyst interviews to protect
 Non issuers don’t occupy the same place with regards to talking about the company to outsiders
• Socially useful convos from sources of MNPI to protect? Much less clear than with issuers

Question 59

10b-5 Evaluation

Answer 59

o GVR thinks 10b-5 is mostly on point w/r/t prohibiting undesirable trade and allowing desirable ones
 GVR: policy should have blanket prohibition on all tippee trades (and tipping) where trade would be prohibited if tipper themselves was the trader (except analyst)
• Problem: it might be hard for the government or plaintiffs to prove a quid pro quo existed between the tipper and tippee (especially true for indirect tippees who may not be aware of the quid pro quo)
o Policy Solution: create a rebuttable presumption that the insider source violated Rule 10b-5 if she disclosed MNPI to an outsider that is likely to be trade on the MNPI; create a rebuttable presumption that the tippee had good reason to know that the MNPI came from an insider source

Question 60

Investment Funds

Answer 60

• As the size (AUM) of the fund increases, harder for managers to come up with market beating opportunities…this idea is based on diminishing returns to scale
o Fund X demonstrates some positive alpha, which causes investors to flock to the fund, Fund X’s AUM increased because investors are looking for positive net alpha opportunities
o But as fund increases, harder to come up with market beating ideas, so the net alpha decreases
o Eventually, Fund X reaches an equilibrium in AUM where net alpha reaches 0%, at which the AUM is at its peak and the manager has no more market beating ideas

Question 61

GVR approach to manipulation

Answer 61

trading strategy is manipulative if all of the following are answered affirmatively
o (1) is the strategy, as a conceptual matter, distinguishable from other, clearly acceptable trading strategies and does it cause social harm?
o (2) does the strategy plausibly fit under dictionary meaning of manipulation?
o (3) are there circumstances under which the strategy can yield positive expected profits and do they occur frequently enough to cause concern?
o (4) are there practical procedures for implementing a ban on the strategy where social gains from reduction/elimination > social costs of doing so, including potentially deterring social valuable txns that might be erroneously identified as part of the practice?
• GVR: manipulation is undesirable on efficiency grounds b/c it harms central social functions re providing liquidity and price accuracy—harm to liquidity is usually more important b/c accuracy will likely be later corrected by event

Question 62

Open Market Manipulation with an External Interest

Answer 62

Involves a trader that has some kind of economic interest in the price of a security independent of price at which she can buy/sell in the open market (e.g. manager with stock options driving up the price)
• No effect on liquidity: does not affect liquidity because liquidity suppliers do not need to widen their bid-ask spreads to protect against the possibility that they are trading with a manipulator
o Completely uninformed trades, manipulator is not acting on some informational advantage that subjects LPs to adverse selection
• Slight negative impact on price accuracy: Price accuracy is temporarily distorted, but there is not a significant harm in the medium and long term
o Impact on price accuracy depends on the time it takes to correct the price distortion
• Negative impact on the cost of contracting: Increases costs of contracting when contract is tied to share price because parties will have to monitor for manipulation…manipulation law can be seen as existing to protect contractual counterparties in contracts that are based on securities prices
• GVR concludes that legal sanctions appropriate only when proven that a trader with external interest makes a purchase just in advance of the moment the security’s price determines the gain that arises from the trader’s external interest

Question 63

Mulheren

Answer 63

• Mulheren holding: manipulative trading is only illegal if purpose of transaction is solely to affect the price of a security. Open market manipulation isn’t illegal – if you conspicuously purchase shares on open market, you’re fine.
o Gov’t failed to prove BRD that Mulheren’s purchase was with intent to raise its price rather than invest

Question 64

Naked Open Market Manipulation

Answer 64

• The purchase of shares and resale under circumstances in which corresponding downward pressure on prices is less severe (circuit split as to illegality under 10(b)
o Results in an average sale price exceeding the average purchase price due to the asymmetric price reaction
o Accomplished exclusively through trading activity and profitable only on the results of that trading activity

it is actually possible to know that there will be a predictable asymmetric price response, situations where, more likely than not, there will be an asymmetric price response in a particular direction: Times of high fear of informed trading, shopping for stops, fragile order book, taking advantage of asymmetric price impacts at different institutions

• Negative impact on liquidity: Lowers liquidity because LPs will defend against the possibility of losing to manipulators and losing again in the price correction process
o Reduces social welfare because of the resulting misallocation of resources over time and of risk
o Reduces share price accuracy further because FVTs have less incentive to seek out info due to increased transaction costs
• Slight negative impact on price accuracy: Distortion of price accuracy but will likely be corrected relatively quickly. If not corrected quickly, a bigger concern.

• Appropriateness of Legal Sanctions: only when it can be proven that she had, at the time of purchase, good reason to believe an asymmetric price reaction would occur (e.g. would need evidence of testing market or comms discussing the manipulation)
o Imposing sanctions without that proof would deter fundamental value trading

Question 65

Spoofing

Answer 65

• Bidding or offering with the intent to cancel the bid or offer before the execution…non-bonafide quote in terms of intent, but it is a real quote, the trader just does not want it to transact

o Submit an order away from the top of the book because you don’t want it to execute…if you want to buy, place a big limit order to sell away from the top of the book
 People draw inferences about the value of assets from other quotes/orders
 If there is a huge limit order, people think that commodity is worth less than I thought, so they lower their ask price
 Hopefully price goes down enough to transact with a genuine buy order that you have placed

• Efficiency?
o Harms investor confidence
o Effect on price accuracy depends on the time period of the distortion
o LPs not harmed because these are not informed orders

Question 66

Misstatement Manipulation

Answer 66

involves a trader who makes a materially false negative statement concerning an issuer that pushes down the issuer’s share price, purchases shares, waits until the truth is disclosed, and then resells the shares
­ Essentially is a type of informed trading – trades on the basis of info he knows and market doesn’t (the falsity of the price-depressing statement)
o Unambiguously damages social welfare by making prices less accurate and reducing liquidity
­ Appropriateness of Legal Sanctions: always because it will decrease liquidity with no positive offset to price accuracy.

Question 67

Broker-Dealer

Answer 67

Any individual or institution whose business involves any of the following broad securities-intermediating activities
o Broker: Any person engaged in the business of effecting transactions in securities for the account of others (i.e. an agent)
o Dealer: Any person engaged in the business of buying and selling securities (i.e. a principal; market-makers)
o Trading venues not registered as a stock exchange

Question 68

BD Agency problem

Answer 68

• Brokers provide trade execution services
o They act as a sort of gatekeeper for customer orders
o Creates an agency problem because customers rely on brokers to accomplished their trading objective, yet there is not a good way to observe their broker’s performance
 The severity of this problem depends on the complexity of the customer’s trading objectives, the sophistication of the customer, and the quality of data available on quotes, transactions, and market structure within a given market
o Solution: Fiduciary DOBE requires BDs to use reasonable efforts to maximize the economic benefit to the client in each transaction
 Common law agency principles, FINRA Rule 5310, and Rule 611

Question 69

Dark Pools

Answer 69

An ATS that promises to keep orders confidential by not displaying them and restricting the parties allowed to trade on the venue
o Most valuable characteristic: Provide a venue where uninformed buyers and sellers who seek to trade substantial amounts of stock can minimize the movement of prices against them and transact at prices potentially superior to the NBBO
 Facilitated by quotes not being displayed and that dark pool operators can exclude traders they believe are informed
o Execution risk is the central vice of the dark pool – you have no idea if your order will execute
 Announcement traders really care about this, so they will use dark pools less

Agency problem: Large investment banks route their brokerage orders to their own DPs even when orders receive inferior execution, Large investment banks ignore their brokerage customers’ instructions to direct their orders to specific venues

Structural Efficiency Problem: Creamskimming of uninformed traders from exchanges;  Increases the amount of informed order flow on exchanges, thereby reducing liquidity on exchanges because of adverse selection and increasing liquidity in DPs
• Causes less informed trading on exchanges because of the higher cost of trading
• Price accuracy ambiguously reduced – depends on whether FVTs can mask their trades

Question 70

Internalization

Answer 70

• BD directly transacts with its customers’ marketable orders
o Guaranteed and immediate execution with slight price improvement over NBBO

• Agency problem
o Customers get worse execution by not being exposed to prices at exchanges

o Biggest worry of the growth of DPs is decrease of price accuracy because of cream skimming of uninformed from exchanges to internalizers

Question 71

Differences between exchanges and ATSs that hamper exchange innovation

Answer 71

• Exchanges have a hard time with trade secret protection because everything they do must be approved by the SEC and is subject to public comments
o Almost impossible to protect a market innovation via trade secrets as an exchange
• ATSs don’t have these same SEC approval requirements
o Disclosure, but not at the same level, so there is still some prospect for protecting trade secrets

• It is cheap to start an ATS, much more expensive to register as an exchange
o So it is easier to offer a niche product as an ATS
• Rules that burden exchanges more
o Quotes that are not immediately executable cannot be protected
 ATSs don’t care about protected quotes, all of their quotes are unprotected
o 610(a), exchanges, but not ATSs, must provide for fair access
 This allows ATSs to discriminate against market participants
 Prevent informed traders from coming in

• Exchanges make a lot of money from the sale of speed technology
• No ATS sems to gain revenue from the sale of either collocation or proprietary data feeds
• As a result, ATS have less reason to be invested in the incumbent market structure that emphasizes speed

Question 72

Maker-Taker

Answer 72

Exchanges pay rebate for NM limit orders it receives and transact, charge fee for marketable orders that arrive (or inverse for taker-maker structure)

o Encourages the posting of non-marketable limit orders thereby enhancing liquidity
 Benign theory: It is dangerous for LPs to post NM limit orders, but dispensible for the functioning of an exchange
• Dangerous because of adverse selection, so compensate those who post these NM limit orders for taking the risk

• Rebates may incentivize brokers to direct its customers orders to the venue that pays the highest rebate, rather than the venue that offers the best execution
o Creates a conflict of interest between brokers who seek to maximize revenue by directing order flow to a specific venue and customers who might receive better execution elsewhere

• Regulatory Response
o Rebates should be pass on directly to customers and fees directly charged to them independent of brokerage commissions
o Won’t guarantee best execution, but would eliminate an incentive for poor execution
o Could also further decimalize the market; $.001 tick size would result in lower spreads, and could reflect fees and rebates in the actual price of the stock

Question 73

Payment for Order Flow

Answer 73

• Brokerage firms sell its order flow of buy and sell marketable orders from a certain customer type (usually retail) to an order-execution facility (internalizer) [about 20% of all trade volume]
o Internalizer promise to execute orders at a slightly improved price over the NBBO
o Essentially outsourcing the broker’s function as a dealer

• Agency Problem: Characterize payment as a bribe that incentivizes the broker to direct its customer orders to the venue that pays the highest rebate, rather than the one that most improves prices, offers best execution
o Creates a conflict of interest between brokers who seek to maximize revenue from selling order flow and customers who might receive better execution elsewhere

o Structural concern re: Cream skimming! The removal of uninformed order flow from the exchange alters liquidity suppliers’ adverse-selection environment

o Key question: whether brokers pass-on the substantial payments they receive for order flow in the form of lower commissions, given that internalizers offer only nominal price improvement
 If not, force brokerage firms to pass on the fees and rebates