FMA Doctoral Consortium Market Microstructure Larry Harris USC and SEC October 16, 2002 San Antonio

An Introductory Caution Data resources in market microstructure are especially strong and seductive. Data mining can be very productive. –But you can never fully satisfy the referee.

Tools and Problems Problem-oriented approaches are most interesting and satisfying. Tools versus problems

Positive and Normative Economics Trader behavior depends on market structure. Choosing the best market structure depends on trader behavior.

Trader Behavior Buy-side traders Gamblers Dealers Bluffers Order anticipators Informed traders

Buy-side Order Strategy How Should Traders Trade? –Break up orders? –Timing? –Limit or market? –Display or hide? Theory on these questions has been started but good empirical work is still scarce.

Buy-side Order Strategy Search strategies depend on trading problems. We don’t know very much about trading problems. Why do people trade?

Buy-side Order Strategy Trading is a search problem. We need better models of the time dimension of liquidity. –Liquidity is more than bid/ask spread. Empirical studies focus too much on market order traders.

Gamblers CBOE’s “Power paks” Long-term relation between informed prices and uninformed traders.

Dealer Behavior Generally well worked over. We need to better understand the relation between dealing and short- term speculation.

Bluffers and Manipulators Bluffers make the provision of liquidity “efficient.” Derivative pricing problems. –Cash settlement. –Crossing markets

Order Anticipators Traders can profit from serially correlated order flows. What causes serially correlated order flows? Should this be regulated?

Informed traders Value traders –Winner’s curse News traders –How do you know whether the information is in the price? Limits to arbitrage

Market Structure Best markets Problems with competition Regulatory issues

What Market Structure Is Best? Continuous versus batch mechanisms. Electronic versus open outcry. Order-driven public auction markets versus quote-driven dealer markets. Segmentation versus consolidation.

Analytic Issues Theoretical comparisons must model endogenous order flows. Empirical comparisons must keep everything else constant. –Side-by-side comparisons must model clientele issues.

Market Criteria Of what benefit are informative prices over short horizons? Of what benefit are continuous markets?

How Do We Tradeoff… Fast versus slow markets? Simplicity and complexity? Dealers versus limit order traders? Competition for best price and competition in exchange services?

Regulatory Issues Agency problems with brokers. Order-flow externality. How should we regulate trading in general? Who should pay for regulation? What is the value of innovation? Specialists

Economics of Coordination Externalities Problems –Market data fees –Trade-through rules –Transparency –Secondary precedence rules –Circuit breakers

Agency Problems Payments-for-order flow Penny stock problems –Whack-a-mole Churning –Client suitability

Current Issues Analysts –What is the value of advice in a zero- sum game? IPO problems What is an exchange? Market center fees Fast, slow and traded through

Related Topics Liquidity and asset pricing –The mutual fund problem Liquidity and contract design –Where is the line between public financing and private financing? Macro- and micro- concepts of liquidity.

Conclusion Very exciting time to work in Finance. Still lots of good topics. Good luck!

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