Dynamic order submission strategies with competition between a dealer market and a crossing network

We analyze a dynamic microstructure model in which a dealer market (DM) and a crossing network (CN) interact for three informational settings. A key result is that coexistence of trading systems generates systematic patterns in order flow, which depend on the degree of transparency. Further, we study overall welfare, measured by the gains from trade of all agents, and compare it with the maximum overall welfare. The discrepancy between both measures is attributable to two inefficiencies. Due to these inefficiencies, introducing a CN next to a DM, as well as increasing the transparency level, not necessarily produces greater overall welfare.     

The strategic specialist and imperfect competition in a limit order market

The empirical literature suggests that the limit order book contains information that might be used by the specialist to his own advantage. I develop a model where there is a strategic specialist who competes against a limit order book and has information about supply. The presence of a strategic specialist in an imperfectly competitive limit order book market induces non-monotonicity of market indicators with respect to the variance of liquidation value. Moreover, the existence of private information about supply significantly affects market performance as it induces, among other effects, lower market liquidity. Finally, this model suggests another link between Kyle’s (1985, 1989) [Kyle, A., 1985. Continuous auctions and insider trading. Econometrica 53, 1315–1336, Kyle, A., 1989. Informed speculators with imperfect competition. Review of Economic Studies 56, 317–356] and Glosten and Milgrom’s (1985) [Glosten, L., Milgrom, P., 1985. Bid, ask and transaction prices in a specialist market with heterogeneously informed markets. Journal of Financial Economics 14, 71–100] models by allowing for strategic behaviour of the specialist.     

A market-clearing role for inefficiency on a limit order book

Limit order markets with stationary dynamics attract equal volumes of market orders and uncanceled limit orders, equalizing the supply and demand for liquidity and immediacy. To maintain this balance, market orders must share any benefit obtained by limit order traders from more efficient trading conditions, such as better order queuing policies. Therefore an efficient market places a low price on immediacy, producing small bid–ask spreads. Furthermore, when price-discreteness leads to a mainly constant spread, cutting the price tick raises surplus. This is modeled with a stochastic sequential game, using stationarity considerations to bypass direct analysis of traders’ intricate market forecasts.     

Informed traders and limit order markets

We consider a dynamic limit order market in which traders optimally choose whether to acquire information about the asset and the type of order to submit. We numerically solve for the equilibrium and demonstrate that the market is a “volatility multiplier”: prices are more volatile than the fundamental value of the asset. This effect increases when the fundamental value has high volatility and with asymmetric information across traders. Changes in the microstructure noise are negatively correlated with changes in the estimated fundamental value, implying that asset betas estimated from high-frequency data will be incorrect.     

A dynamic limit order market with fast and slow traders

This paper considers the role of high-frequency trading in a dynamic limit order market. Fast traders? ability to revise their quotes quickly after news arrivals helps to reduce the inefficiency that is rooted in the risk of being picked off, which increases trade. However, their presence induces slow traders to strategically submit limit orders with a lower execution probability, thereby reducing trade. Because speed is a source of market power, it enables fast traders to extract rents from other market participants and triggers a costly arms race that reduces social welfare. The model generates a number of testable implications concerning the effects of high-frequency trading in limit order markets.     

Monitoring and limit order submission risks

This paper presents a formal analysis of the relation between monitoring and limit order submission risk. With heterogeneous information, limit order traders face two types of risk. First, they may be “picked off” when prices change unexpectedly after the limit order is entered (known as free trading option risk). Second, they face the possibility that their limit order will not result in a trade. To mitigate these risks, traders can monitor information and prices and cancel or revise their orders as needed. But such monitoring is costly, resulting in a trade-off between the cost of monitoring and the risks of limit order submission. The model predicts that if the stock is actively traded, limit order submission risks and order cancellations/revisions are positively related. Further, shares with a wide bid-ask spread will tend to have a lower rate of order cancellations and revisions than shares with small bid-ask spreads. Finally, the model suggests that if larger capitalization stocks have lower costs of gathering information (and hence more intense monitoring of limit orders), there will be more cancellations and revisions in limit orders. A sample of 23 liquid stocks provides evidence that is consistent with these three main hypotheses.     

Hidden liquidity: An analysis of order exposure strategies in electronic stock markets

Many stock exchanges choose to reduce market transparency by allowing traders to hide some or all of their order size. We study the costs and benefits of order exposure and test hypotheses regarding hidden order usage using a sample of Euronext-Paris stocks, where hidden orders represent 44% of the sample order volume. Our results support the hypothesis that hidden orders are associated with a decreased probability of full execution and increased average time to completion, and fail to support the alternate hypothesis that order exposure causes defensive traders to withdraw from the market. However, exposing rather than hiding order size increases average execution costs. We assess the extent to which non-displayed size is truly hidden and document that the presence and magnitude of hidden orders can be predicted to a significant, but imperfect, degree based on observable order attributes, firm characteristics, and market conditions. Overall, the results indicate that the option to hide order size is valuable, in particular, to patient traders.     

Limit-order submission strategies under asymmetric information

This paper provides evidence that informed traders dominate the response of limit-order submissions to shocks in a pure limit-order market. In the market we study, informed traders are highly sensitive to spreads, volatility, momentum and depth. By contrast, uninformed traders are relatively insensitive to all these market conditions. The dominance of the informed over limit-order submissions is magnified by contrasts between them and the uninformed in the use of aggressively-priced limit orders.     

Liquidity and market efficiency

Short-horizon return predictability from order flows is an inverse indicator of market efficiency. We find that such predictability is diminished when bid-ask spreads are narrower, and has declined over time with the minimum tick size. Variance ratio tests suggest that prices were closer to random walk benchmarks in the more liquid decimal regime than in other ones. These findings indicate that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.     

Competition, interlisting and market structure in options trading

This paper applies a game theory approach to examine the effects of a market structure change in options trading from a monopoly to a Cournot-type oligopoly that occurred in two successive periods on the Montreal exchange. We analyze the intra-day behaviour of option bid-ask spreads and find that cross-listing has a differential impact on spreads, affecting quoted but not effective spreads under oligopoly. We also find that the impact of the change in structure on effective spreads comes mostly from an increase in limit orders and is consistent with a switch from Cournot to Bertrand-type strategic behaviour for such orders. We conclude that market structure effects within an options exchange are enough to realize most of the benefits of inter-market competition even in the context of market thinness.     

Controlling shareholders and market timing in share issuance

We examine market timing in the equity issuance of firms controlled by large shareholders using a hand-collected data set of controlling shareholders' ownership stakes in Chile between 1990 and 2009. When a firm issues shares, the controlling shareholder can either maintain or change his ownership stake depending on how many of the new shares he subscribes. Issuance predicts poor future returns and is preceded by high returns, but only when the controlling shareholder's stake is significantly reduced. Consistent with market timing, the results are stronger in the absence of institutional investors and in hot issuance markets.     

The submission of limit orders or market orders: The role of timing and information in the Reuters D2000-2 system

Recent work in the market microstructure literature suggests that the speed with which orders arrive in the market impacts traders' order submission decisions. In this study we use an asymmetric autoregressive conditional duration (ACD) model to empirically investigate the influence on the submission of limit and market orders of changes in the time between the past submissions of different types of orders, changes in the slope of the limit order book, and changes in price uncertainty. We find that the expected time between the arrivals of successive orders in the foreign exchange market depends on the previous type of order submitted and the slope on both sides of the order book. Price uncertainty (volatility) plays a secondary role after accounting for the impact of changes in the slope of the order book. Lastly, we find that there are fundamental changes in the level of information contained in the submission of orders at the opening and closing of markets.     

Momentum strategies in commodity futures markets

The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the constituents of the long–short portfolios reveals that the momentum strategies buy backwardated contracts and sell contangoed contracts. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commodity-based relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios.     

Local investors,price discovery,and market efficiency

This study examines the effect of locally informed investors on market efficiency and stock prices using large power outages, which are exogenous events that constrain trading. Turnover in stocks headquartered in an outage area with 0.5% of U.S. electrical customers drops by 3–7% on the first full day of the outage, and bid–ask spreads narrow by 2.5%. Firm-specific price volatility is 2.3% lower on blackout dates. This effect is larger for smaller, lesser-known stocks and in higher income areas. Consistent with a valuation discount and higher expected returns for stocks with more informed traders, firms with a one-standard-deviation higher local trading propensity have market-to-book values that are 5% lower, Tobin's Q that is 6% lower, annualized four-factor alphas that are 1.2% higher, and average spreads that are 6.5% higher. Together, the evidence suggests that informed investors contribute disproportionately to both liquidity and price discovery, and that these contributions are reflected in valuations and expected returns.     

Stock market liquidity and firm value

This paper investigates the relation between stock liquidity and firm performance. The study shows that firms with liquid stocks have better performance as measured by the firm market-to-book ratio. This result is robust to the inclusion of industry or firm fixed effects, a control for idiosyncratic risk, a control for endogenous liquidity using two-stage least squares, and the use of alternative measures of liquidity. To identify the causal effect of liquidity on firm performance, we study an exogenous shock to liquidity—the decimalization of stock trading—and show that the increase in liquidity around decimalization improves firm performance. The causes of liquidity's beneficial effect are investigated: Liquidity increases the information content of market prices and of performance-sensitive managerial compensation. Finally, momentum trading, analyst coverage, investor overreaction, and the effect of liquidity on discount rates or expected returns do not appear to drive the results.     

Uncertainty,market structure,and liquidity

In this study we show that market uncertainty [measured by the Chicago Board Options Exchange Market Volatility Index (VIX)] exerts a large market-wide impact on liquidity, which gives rise to co-movements in individual asset liquidity. The effect of VIX on stock liquidity is greater than the combined effects of all other common determinants of stock liquidity. We show that the uncertainty elasticity of liquidity (UEL: percent change in liquidity given a 1% change in VIX) has increased around regulatory changes in the US markets that increased the role of public traders in liquidity provision, reduced the minimum allowable price variation, weakened the affirmative obligation of NASDAQ dealers, and abolished the specialist system on the NYSE.     

Liquidity and market efficiency: A large sample study

Chordia et al. (2008, hereafter CRS) examine short horizon return predictability from past order flows of large, actively traded NYSE firms across three tick size regimes and conclude that higher liquidity facilitates arbitrage trading which enhances market efficiency. We extend CRS to a comprehensive sample of all NYSE firms and examine the dynamics between liquidity and market efficiency during informational periods. Our results indicate that although all NYSE firms experience an overall improvement in market efficiency across periods of different tick size regimes, this improvement varies significantly across the portfolios of sample companies formed on the basis of trading frequency, market capitalization, and trading volume. After controlling for these factors, we further document a positive association between a continuous measure of liquidity and market efficiency, and show that this effect is amplified during periods that contain new information, as reflected in high adverse selection component of the bid-ask spread.     

Stock salience and the asymmetric market effect of consumer sentiment news

We document asymmetric announcement effects of consumer sentiment news on United States stock and stock futures markets. While a negative market effect occurs upon the release of bad sentiment news, there is no market reaction for the counterpart good news. This supports the “negativity effect” hypothesis. Notably, this effect seems most likely to occur in salient stocks, which is consistent with the availability heuristic.     

The market for borrowing corporate bonds

This paper describes the market for borrowing corporate bonds using a comprehensive data set from a major lender. The cost of borrowing corporate bonds is comparable to the cost of borrowing stock, between 10 and 20 basis points, and both have fallen over time. Factors that influence borrowing costs are loan size, percentage of inventory lent, rating, and borrower identity. There is no evidence that bond short sellers have private information. Bonds with Credit Default Swaps (CDS) contracts are more actively lent than those without. Finally, the 2007 Credit Crunch does not affect average borrowing costs or loan volume, but does increase borrowing cost variance.     

Recent trends in trading activity and market quality

We explore the sharp uptrend in recent trading activity and accompanying changes in market efficiency. Higher turnover has been associated with more frequent smaller trades, which have progressively formed a larger fraction of trading volume over time. Evidence indicates that secular decreases in trading costs have influenced the turnover trend. Turnover has increased the most for stocks with the greatest level of institutional holdings, suggesting professional investing as a key contributor to the turnover trend. Variance ratio tests suggest that more institutional trading has increased information-based trading. Intraday volatility has decreased and prices conform more closely to random walk in recent years. The sensitivity of turnover to past returns has increased and cross-sectional predictability of returns has decreased significantly, revealing a more widespread use of quantitative trading strategies that allow for more efficient securities prices.