week 3 Flashcards
How was trading conducted on the NSYE?
o One specialist for each stock
o They have affirmative obligations to offer liquidity – traders of last resort
o Negative obligations – yield to public orders
How was trading conducted continued?
o House Broker / Commission Brokers
Represent brokerage houses and deal with the public and handle orders originate off the floor
Now they tend to handle large and complex executions needed by institutional customers
o Independent Brokers
Known as $2 brokers or broker’s broker
They are able to execute complex orders which require skills and reputation on the floor
o Floor Traders / Competitive Traders
Trade in stocks on the floor for an account in which there is an interest
o Floor trading diminished since the merger
DMMs have been involved in less than 1/30 transactions
DMMs
o Face regularly light obligations
o Must quote at the NBBO at least 15% of the time
o Maintain quotes not more than 8% away from the NBB/NBO
Difference between DMM and market specialist
o DMM no longer maintains order books
o Orders are processed by the trading system; SDBK
NBBO
o CQS consolidates and broadcasts each market center’s best bid and offer
o NBBO is a regulation by the SEC that requires brokers to execute customer trades at the best prices available for buying and selling securities
How is trading conducted on ASX
o Centralized limit order book
o No DMMs, no specialists
Internalization Crossing Networks
o Brokers are internalizing the orders from the clients
o Refers to the system that brokers use to trade against their clients
Dark Pool
o A place where brokers can trade against themselves / institutional traders / investors who have access to that dark pool
What is liquidity?
o Refers to an asset’s ability to be easily purchased or sold without causing significant change in the price of the asset
o Assets can be easily traded with low transactions costs at any time with little impact on the asset’s price
Definition of liquidity
o A market is liquid if
Uninformed traders can quickly buy or sell large size when they want at a low transaction cost
o Three key points: size of trade, how long you require, whether you need to pay a cost / premium to get the shares
Known as the trade offs
Kyle 1985 Liquidity dimensions
o Width – The cost per unit
o Depth – The size available at a given cost
o Resiliency – Time that passes before traders recognize uninformed traders have caused prices to change
Who are institutional traders
o Institutional investors
Mutual funds, pension funds
Buy side institutions accept money from investors for the purpose of investing on their behalf
o Institutional transactions are executed by professional traders in the institutions or acting as their agents
The execution of these orders will likely impact price
Types of investment company types
o Closed-end investment company
Issue specified number of shares that can be traded on the exchange
o Open-end investment company
Accept additional funds and repurchase shares directly from investments
o Exchange traded funds
Shares are traded on exchange but differ from closed-end investment companies
Unregistered investment companies
o Pension funds
o Private Equity
o Hedge funds
How do institutions trade?
o Large trading volume; 75-80% estimated
o Common for institutions to break their order into smaller tranches spread over extended periods of time
Slice and dice -> risk of being front run; trading strategy recognized
Missed opportunity cost
• Extended period of time, the price could be significantly different at two different points of time
o Complex Orders
Iceberg orders -> Only a small part of an order is shown in the limit order book, larger part is unknown
• Use this to implement their strategy without tipping off the market
• Risk associated: detectable
• However, NASDAC randomizes the pick size
o Trading strategies
Minimise trading costs by revealing minimal information about their trading intentions to the market
Require anonymity however they want to see the orders of everyone else
o Algorithmic Trading
Automated trading
Minimise the price impact over time
Measurement of trade impact = trade slippage; price of the order of all fulfilled – price of submitted orders
More people have started algorithmic trading
Dark Pools
o Do not post quotes or transaction prices
o Function in parallel with traditional markets
Types of dark Pools
o Public crossing networks
Cross buy and sell orders at the spread mid-point
o Internalisation pools
Broker provides both buy and sell flow from its own proprietary desk and its customers
o Why trade in dark pools?
Price improvement -> offer a better price than stock exchange
Crossing networks
Non-Displayed, new form of trading
o Issues
Transparency
Do not see who is trading and what is the best available price in the market
Causes an issue for price discovery process
Self-selection
• Dark pool is more attractive for uninformed traders
Dark Executions
o Typically arise from one of the following mechanisms
A hidden limit order in a limit order market
A NASDAQ market marker trades against a customer order at the NBBO at a time when the MM’s own quotes are behind the NBBO
• Internalization
The trade occurs in a crossing network or dark pool that posts no quotes of its own, but matches buyers and sellers at prices determined by the NBBO
• Trades in dark pools
Stealth Trading
o Traders announce their intentions
o Attempts to attract more liquidity providers to the market
o If trades are not information driven -> better prices vs stealth
What are the institutional trading needs
o Volatility
Share prices fluctuate with market uncertainty and also illiquidity in the market
o Transparency
Everyone wants markets to be transparent, but no one wants anyone else to see what they themselves are doing
o Consolidation of order flow
Refers to the pooling of order flow in one market centre
• Increases order interaction, concentrates liquidity
• Improves accuracy of price discovery
Fragmentation both spatial and temporal due to slice and dice
• Affects quantity discovery and price discovery
• Increases intraday price volatility
Price impact of institution trading
o Price changes are decomposed into two components
Change in the market’s perception of the security’s value (permanent)
Price movement necessary to provide the liquidity to absorb the block (temporary)
o Kraws and Stoll and Saar
Documented asymmetric reaction to block trades
Buy orders see much larger upward effect than downward effect by sell orders
o Chan and Lakonishok and Saar
Buy orders are more informationally driven
Liquidity needs drive many sales
More pool of stocks from which to buy than sell
Restriction on short selling
Funds cannot borrow to invest
