©R. Schwartz Equity Markets: Trading and Structure Slide 1 Topic 7

©R. Schwartz Equity Markets: Trading and Structure Slide 2 We have thus far considered The plain vanilla, order driven market A simple limit order book Continuous trading and call auction facilities The Plain Vanilla Order Drive Market

©R. Schwartz Equity Markets: Trading and Structure Slide 3 Is Trading Really This Simple?

©R. Schwartz Equity Markets: Trading and Structure Slide 4 Electronic Order Book Systems Work Well For Retail order flow Liquid stocks Non-stressful conditions But A Plain Vanilla Electronic Trading System Cannot do it All

©R. Schwartz Equity Markets: Trading and Structure Slide 5 More Structure is Needed!

©R. Schwartz Equity Markets: Trading and Structure Slide 6 Emergence of the Modern Markets Intermediation on the New York Stock Exchange Intermediation at NASDAQ The Need for Intermediation Read on Your Own Text Pages

©R. Schwartz Equity Markets: Trading and Structure Slide 7 The Ecology of an Order Driven Market Can Break Down Free riding Small and mid-cap stocks Stressful conditions

©R. Schwartz Equity Markets: Trading and Structure Slide 8 A bear market Advent of news Derivatives expirations Momentum trading Daily openings Arrival of a 300,000 share order Stressful Conditions

©R. Schwartz Equity Markets: Trading and Structure Slide 9 Market Maker Operations

©R. Schwartz Equity Markets: Trading and Structure Slide 10 TraderEx Dealer Screen

©R. Schwartz Equity Markets: Trading and Structure Slide 11 Market Maker Services Immediacy Supplemental liquidity Price discovery Animation Price improvement (pages )

©R. Schwartz Equity Markets: Trading and Structure Slide 12 Immediacy Market maker practices are designed to facilitate the rapid execution of customer orders However, orders are commonly traded patiently (i.e., without immediacy) – Upstairs negotiation of large block trades – Breaking up large orders for submission over time – Limit orders

©R. Schwartz Equity Markets: Trading and Structure Slide 13 Market Maker Revenues Spread Trading the Order Flow Commissions

©R. Schwartz Equity Markets: Trading and Structure Slide 14 Market Maker Costs Inventory cost: Cost of carrying unbalanced inventory Information cost: Cost of trading with better informed participant

©R. Schwartz Equity Markets: Trading and Structure Slide 15 What Makes a Market Maker Successful? Inventory control Trading the order flow carefully Ability to hide/disguise large positions Knowledge of customers (source of the order flow) is also important in practice Receiving a large percentage of the order flow

©R. Schwartz Equity Markets: Trading and Structure Slide 16 Quotes and Inventory Positions

©R. Schwartz Equity Markets: Trading and Structure Slide 17 Inventory Control in TraderEx If P* jumps above your offer, your customers will, on net, be buyers and your inventory will fall As your inventory falls, you raise your bid and offer The higher bid attracts sellers and the higher offer discourages buyers What happens to your inventory if your bid is raised above P*? Your inventory is controlled by adjusting your bid and offer relative to the unobserved P*

©R. Schwartz Equity Markets: Trading and Structure Slide 18 Transparency "Shares sold to a market maker are still for sale” You do not want your inventory revealed by a trade publication As a Market Maker, How Transparent Do You Want the Market To Be? After you acquire a large inventory in the process of servicing a customer, you must work off that position

©R. Schwartz Equity Markets: Trading and Structure Slide 19 Knowing their customers Offering an array of services Developing customer relationships; this results in Preferencing Quote matching A market spread that is greater than it would be in an order-driven environment How Market Makers Compete

©R. Schwartz Equity Markets: Trading and Structure Slide 20 Market Maker Preferencing What effect would preferencing have on The volume of orders you receive? Your inventory control? Your profitability? Under which regime would you prefer to operate: Preferencing, or Strict price and time priorities?

©R. Schwartz Equity Markets: Trading and Structure Slide 21 Block Trading

©R. Schwartz Equity Markets: Trading and Structure Slide 22 The Challenge How do you handle an order to buy half a million shares of a stock that, on average, trades 300,000 shares a day? Dealer capital Shop the order Slice and dice the order and submit the tranches to an electronic platform Call auction Block trading facility

©R. Schwartz Equity Markets: Trading and Structure Slide 23 Costs Bid-ask spread Market impact Opportunity cost Implementation short fall Losses due to bad market timing

©R. Schwartz Equity Markets: Trading and Structure Slide 24 Performance Measure Difficult to measure performance Need a good benchmark Do not make assessments on a trade-by-trade basis TraderEx point score

©R. Schwartz Equity Markets: Trading and Structure Slide 25 Electronic Intermediaries Dark pools Crossing network (e.g., Posit, Matchpoint) Negotiation venue (e.g., Liquidnet) Order matching system (e.g., Pipeline)

©R. Schwartz Equity Markets: Trading and Structure Slide 26 Dark Pools Free Riding On Price Discovery While Offering Quantity Discovery Institutions keep their orders hidden to control their transaction costs How do they find each other and trade? The problem is called Quantity Discovery

©R. Schwartz Equity Markets: Trading and Structure Slide 27 Shortcomings of Dark Pools Lack transparency Low crossing rates Exclusivity Sheer numbers

©R. Schwartz Equity Markets: Trading and Structure Slide 28 TraderEx Block Trading Block Board

©R. Schwartz Equity Markets: Trading and Structure Slide 29 TraderEx Block Trading Institutional Orders Pipeline Order Flow is separated from the Order Book Price of order execution is determined from the Market (Order Book) Minimum Order Size Constraints

©R. Schwartz Equity Markets: Trading and Structure Slide 30 Passive Order – Bid price is below the bid/ask spread midpoint Active Order – Bid price is above the midpoint Vice versa for ask price Market / Limit Reward for being Aggressive TraderEx Pipeline Orders and Execution

©R. Schwartz Equity Markets: Trading and Structure Slide 31 TraderEx Pipeline Colors and Features Orange : There is a pipeline order for that stock Orange with Red : You have placed a sell order Orange with Green : You have placed a buy order Yellow with Green : You have placed an aggressive buy order and there is a passive sell order Yellow with Red : You have placed an aggressive sell order and there is a passive buy order

©R. Schwartz Equity Markets: Trading and Structure Slide 32 Take (Hit) the Passive Offer (Bid) Bid/Ask spread protection TraderEx Pipeline Take Bid