Last look

In over-the-counter markets, a trader typically sources indicative quotes from a number of competing liquidity providers, and then sends a deal request on the best available price for consideration by the originating liquidity provider. Due to the communication and processing latencies involved in this negotiation, and in a continuously evolving market, the price may have moved by the time the liquidity provider considers the trader’s request. At what point has the price moved too far away from the quote originally shown for the liquidity provider to reject the deal request? Or perhaps the request can still be accepted but only on a revised rate? ‘Last look’ is the process that makes this decision, i.e. it determines whether to accept—and if so at what rate—or reject a trader’s deal request subject to the constraints of an agreed trading protocol. In this paper, I study how the execution risk and transaction costs faced by the trader are influenced by the last look logic and choice of trading protocol. I distinguish between various ‘symmetric’ and ‘asymmetric’ last look designs and consider trading protocols that differ on whether, and if so to what extent, price improvements and slippage can be passed on to the trader. All this is done within a unified framework that allows for a detailed comparative analysis. I present two main findings. Firstly, the choice of last look design and trading protocol determines the degree of execution risk inherent in the process, but the effective transaction costs borne by the trader need not be affected by it. Secondly, when a trader adversely selects the liquidity provider she chooses to deal with, the distinction between the different symmetric and asymmetric last look designs fades and the primary driver of execution risk is the choice of trading protocol.     

Dancing in the dark: post-trade anonymity,liquidity and informed trading

We analyze the impact of post-trade anonymity on liquidity and informed trading in an order driven stock market. The German stock market introduced the Central Counterparty (CCP) in March 2003 for German equities traded on its anonymous electronic trading platform Xetra leading to a major change in its existing transparency regime. Before the introduction trader IDs were revealed to the counterparties of a trade, with the introduction of the CCP even after the transaction the traders remain anonymous. Previous theoretical and empirical research documents that pre-trade anonymity results in increased liquidity, while results on post-trade anonymity are mixed. We find a significant increase in liquidity measured through a reduction of 25% in implicit transaction costs. We also document that the arrival rate of informed traders is reduced in the anonymous setting. Following recent findings of Bloomfield et al. (J Finan Econ 75:165–199, 2005) that informed traders take on the role of liquidity providers we interpret our findings as indication that informed traders change their behavior in providing liquidity more aggressively in an anonymous environment.     

The impact of mandatory IFRS reporting on institutional trading costs: Evidence from Australia

This study examines the impact of mandatory International Financial Reporting Standards (IFRS) on the market quality of the Australian Securities Exchange (ASX) 200 constituent stocks. Using traditional metrics that are consistent with prior literature (i.e., bid‐ask spreads), the first stage analysis confirms that stock liquidity has improved. However, when the analysis is extended to consider the trading costs incurred by market participants (i.e., execution shortfall), results suggest liquidity has not changed significantly. The paper utilizes rich unique datasets that contain detailed trade information, and findings are robust after controlling for trade difficulty and market conditions. In the era of High Frequency Trading (HFT) and occurrences of ‘fleeting’ liquidity, this paper provides some evidence that while IFRS may have enhanced ‘visible’ bid‐ask spreads, tangible liquidity for market participants, particularly global institutional investors, has not improved significantly.     

Market transparency: who wins and who loses?

This study uses laboratory experiments to determine the effectsof trade and quote disclosure on market efficiency, bid-askspreads, and trader welfare. We show that trade disclosure increasesthe informational efficiency of transaction prices, but alsoincreases opening bid-ask spreads, apparently by reducing market-makers'incentives to compete for order flow. As a result, trade disclosurebenefits market makers at the expense of liquidity traders andinformed traders. We find that quote disclosure has no discernibleeffects on market performance. Overall our results demonstratethat the degree of market transparency has important effectsof market equilibria and on trader and market-maker welfare.     

Asset market equilibrium with liquidity risk

This paper derives an equilibrium asset pricing model with endogenous liquidity risk. Liquidity risk is modeled as a stochastic quantity impact on the price from trading, where the size of the impact depends on trade size. Under a strong set of assumptions, we prove that a unique equilibrium liquidity cost process and a unique equilibrium price process exists for our economy. We characterize the market’s state price density, which enables the derivation of the risk-return relation for the stock’s expected return including liquidity risk. We derive a generalized intertemporal CAPM and consumption CAPM for these markets. In contrast to the traditional models without liquidity risk, there is an additional systematic liquidity risk factor which is related to the stock return’s covariation with the market’s stochastic liquidity cost. Traditional transaction costs are a special case of our formulation.     

Internalisation by electronic FX spot dealers

Dealers in over-the-counter financial markets provide liquidity to customers on a principal basis and manage the risk position that arises out of this activity in one of two ways. They may internalise a customer's trade by warehousing the risk in anticipation of future offsetting flow, or they can externalise the trade by hedging it out in the open market. It is often argued that internalisation underlies much of the liquidity provision in the currency markets, particularly in the electronic spot segment, and that it can deliver significant benefits in terms of depth and consistency of liquidity, reduced spreads, and a diminished market footprint. However, for many market participants, the internalisation process can be somewhat opaque, data on it are scarcely available, and even the largest and most sophisticated customers in the market often do not appreciate or measure the impact that internalisation has on their execution costs and liquidity access. This paper formulates a simple model of internalisation and uses queuing theory to provide important insights into its mechanics and properties. We derive closed form expressions for the internalisation horizon and demonstrate—using data from the Bank of International Settlement's triennial FX survey—that a representative tier 1 dealer takes on average several minutes to complete the internalisation of a customer's trade in the most liquid currencies, increasing to tens of minutes for emerging markets. Next, we analyse the costs of internalisation and show that they are lower for dealers that are willing to hold more risk and for those that face more price-sensitive traders. The key message of the paper is that a customer's transaction costs and liquidity access are determined both by their own trading decisions as well as the dealer's risk management approach. A customer should not only identify the externalisers but also distinguish between passive and aggressive internalisers, and select those that provide liquidity compatible with their execution objectives.     

Market transparency,liquidity externalities,and institutional trading costs in corporate bonds

We develop a simple model of the effect of public transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after initiation of the TRACE reporting system. Trade execution costs fell approximately 50% for bonds eligible for TRACE transaction reporting, and 20% for bonds not eligible for TRACE reporting, suggesting the presence of a “liquidity externality.” The key results are robust to changes in variables, such as interest rate volatility and trading activity that might also affect execution costs. Market shares and the cost advantage to large dealers decreased post-TRACE. These results indicate that market design can have first-order effects, even for sophisticated institutional customers.     

Optimal trading strategy and supply/demand dynamics

In this paper, we study how the intertemporal supply/demand of a security affects trading strategy. We develop a general framework for a limit order book market to capture the dynamics of supply/demand. We show that the optimal strategy to execute an order does not depend on the static properties of supply/demand such as bid–ask spread and market depth, it depends on their dynamic properties such as resilience: the speed at which supply/demand recovers to its steady state after a trade. In general, the optimal strategy is quite complex, mixing large and small trades, and can substantially lower execution cost. Large trades remove the existing liquidity to attract new liquidity, while small trades allow the trader to further absorb any incoming liquidity flow.     

Adverse selection in cryptocurrency markets

In this article we investigate the influence that information asymmetry may have on future volatility, liquidity, market toxicity, and returns within cryptocurrency markets. We use the adverse-selection component of the effective spread as a proxy for overall information asymmetry. Using order and trade data from the Bitfinex exchange, we first document statistically significant adverse-selection costs for major cryptocurrencies. Also, our results suggest that adverse-selection costs, on average, correspond to 10% of the estimated effective spread, indicating an economically significant impact of adverse-selection risk on transaction costs in cryptocurrency markets. Finally, we document that adverse-selection costs are important predictors of intraday volatility, liquidity, market toxicity, and returns.     

PIP Transactions,Price Improvement,Informed Trades and Order Execution Quality

This study focuses on innovations in order execution processes within the context of the Boston Option Exchange (BOX). More specifically, it examines the impact of the Price Improvement Process (PIP) on options quoted, effective and realised proportional spreads. We consider the PIP as a mechanism that allows the market maker to ‘internalise’ the transaction. We show that PIP transactions are associated with wider bid/ask proportional quoted spreads than non‐PIP transactions, in spite of the temporary narrowing of the effective proportional spread during PIP. We identify informed traders by focusing on the direction of trade. Using an original data set, we show that PIP transactions follow signals in the form of buy/sell orders by informed traders. We also show that PIP is a mechanism that allows the market maker to internalise a position in the same direction as that of the informed trader. We conclude that PIP does not improve the efficiency of the market but simply allows the market maker to benefit at the expense of uninformed traders.