week 3

Question 1

 How was trading conducted on the NSYE?

Answer 1

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

Question 2

 How was trading conducted continued?

Answer 2

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

Question 3

 DMMs

Answer 3

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

Question 4

 Difference between DMM and market specialist

Answer 4

o DMM no longer maintains order books

o Orders are processed by the trading system; SDBK

Question 5

 NBBO

Answer 5

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

Question 6

 How is trading conducted on ASX

Answer 6

o Centralized limit order book

o No DMMs, no specialists

Question 7

 Internalization Crossing Networks

Answer 7

o Brokers are internalizing the orders from the clients

o Refers to the system that brokers use to trade against their clients

Question 8

 Dark Pool

Answer 8

o A place where brokers can trade against themselves / institutional traders / investors who have access to that dark pool

Question 9

 What is liquidity?

Answer 9

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

Question 10

 Definition of liquidity

Answer 10

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

Question 11

 Kyle 1985 Liquidity dimensions

Answer 11

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

Question 12

 Who are institutional traders

Answer 12

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

Question 13

 Types of investment company types

Answer 13

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

Question 14

 Unregistered investment companies

Answer 14

o Pension funds
o Private Equity
o Hedge funds

Question 15

 How do institutions trade?

Answer 15

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

Question 16

 Dark Pools

Answer 16

o Do not post quotes or transaction prices

o Function in parallel with traditional markets

Question 17

 Types of dark Pools

Answer 17

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

Question 18

o Why trade in dark pools?

Answer 18

 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

Question 19

 Dark Executions

Answer 19

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

Question 20

 Stealth Trading

Answer 20

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

Question 21

 What are the institutional trading needs

Answer 21

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

Question 22

 Price impact of institution trading

Answer 22

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)

Question 23

o Kraws and Stoll and Saar

Answer 23

 Documented asymmetric reaction to block trades

 Buy orders see much larger upward effect than downward effect by sell orders

Question 24

o Chan and Lakonishok and Saar

Answer 24

 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