dr. michael pagano, cfa the robert j. and mary ellen darretta endowed chair in finance
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Market Structure, Trading, and Liquidity Slide 1
MBA 8750 – Current Topics SeminarThe Current State and Structure of U.S.
Financial Markets: Implications from the 2010 “Flash Crash”
Dr. Michael Pagano, CFAThe Robert J. and Mary Ellen Darretta
Endowed Chair in FinanceProfessor of Finance
Villanova School of Business
May 12, 2011
Market Structure, Trading, and Liquidity Slide 2
Overview of SeminarAgenda Item Presenter Time
Welcome & Introduction to the Seminar Mike Pagano 6:00-6:05
The “Flash Crash” and what it means for you and your firm
Mike Pagano 6:05-6:30
Open Outcry Trading Exercise All 6:30-6:50
The Role of Options in Investing and Markets Lou DePaul 6:50-8:00
How Trading Firms can add value for Investors Mike Pagano and All 8:00-8:45
Wrap-up and Post-Work Mike Pagano 8:45-9:00
Market Structure, Trading, and Liquidity3
Is trading this simple? …
Market Structure, Trading, and Liquidity4
or slightly more difficult ??
Market Structure, Trading, and Liquidity5
What Motivates Trading?
1. New information (unexpected news)
2. Liquidity needs
3. Divergent expectations (people agree to disagree)
4. Technical (noise) trading
Market Structure, Trading, and Liquidity Slide 6
Fundamental Financing ChannelsFirm Investor
Firm InvestorIB / CB
Buyer Seller
Agent
Exchange
or Market Maker
Agent
Market Structure, Trading, and Liquidity Slide 7
The Equity Markets
U.S. Equity Market Centers National Markets: NYSE, Nasdaq, BATS, DirectEdge
Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia
Over-the-Counter Market (OTC) Alternative Markets (ATSs, ECNs, “Dark Pools”), e.g.:
– INET (ECN part of Nasdaq now)– Arca (part of NYSE Euronext now) – POSIT (Investment Technology Group)– Liquidnet and Pipeline (private block trading networks)– Sell-side Dark Pools run by Goldman, Credit Suisse, etc.
Market Structure, Trading, and Liquidity Slide 8
Trading Players
• Retail Investors• Institutional Investors• High Frequency Traders (HFTs)• Speculators• Dealers / Market Makers• Brokers• Exchanges• Off-Exchange Trading Systems• Corporate Issuers• Regulators
Market Structure, Trading, and Liquidity Slide 9
Major Trading Issues
• Liquidity
• Informative Prices
• Volatility
• Transaction Costs
• Trading Profits
• Net Investment Returns
Market Structure, Trading, and Liquidity Slide 10
The Iceberg of Transaction Costs
Source: Plexus Group, 2003
Commission 5 ¢ (17 bp)
ImpactImpact10 ¢ (34 bp)10 ¢ (34 bp)
Delay23 ¢ (77 bp)
Missed Trades9 ¢ (29 bp)
Market Structure, Trading, and Liquidity Slide 11
Trading Cost Components• Total Cost = Commission
+ Impact (intra-day) + Delay (inter-day)
approx. 157 bps (one-way)
314 bps (round-trip!)
• What is the cumulative impact on a 10% gross annual return over just 1 year?
• Answer: Net return is only 6.57% (a 34.2% decrease!)
Market Structure, Trading, and Liquidity Slide 12
10:50 10:55 11:00
PublicBuyer
PublicSeller
LimitOrder
Executes
Placesa BuyLimit
Order
Order Driven Market
The limit order book brings
buyer& seller together
The limit order book brings
buyer& seller together
Market Structure, Trading, and Liquidity Slide 13
BIDS PRICE OFFERS
11.30 91
11.25 0
11.20 52
11.15 24
11.10 7
11.05
11.00
35 10.95
70 10.90
0 10.85
20 10.80
67 10.75
39 10.70
46 10.65
The Limit Order Book
Bid – Ask Spread(10.95 - 11.10)
Air Pocket
Air Pocket
Market Structure, Trading, and Liquidity Slide 14$21.00
$22.00
$23.00
$24.00
$25.00
$26.00
$27.00
$28.00
Ask
Bid
P*
Day 1 Day 2
P* and Best Bid and Offer Quotes
Market Structure, Trading, and Liquidity Slide 15
Order Flow is “Fuel” For a Market
Order Flow = Liquidity
An excellent system will not operate if it does not receive
Critical Mass Order Flow“Order flow attracts order flow”
Market Structure, Trading, and Liquidity Slide 16
Liquidity
Main Attributes of a liquid asset Breadth: orders on the book exist at an array of
prices in the close neighborhood above and below the price at which shares are currently trading.
Depth: orders are of large size. Resiliency: price changes due to temporary order
imbalances quickly attract new orders to the market, thereby restoring reasonable share values.
Frequent trading (at high speed).
Market Structure, Trading, and Liquidity Slide 17
The Raison d’être of Algorithmic Trading
o Dynamic price discovery
o The fast speed in which events can occur
o Exploit Market inefficiencies to ↓ costs and ↑ profits
Market Structure, Trading, and Liquidity Slide 18
The 9/30/2010 CFTC - SEC “Flash Crash” Report
Market Structure, Trading, and Liquidity Slide 19
Flash Crash Summary of EventsThe events of May 6 can be separated into 5 phases (shown in Figures 1.1
and 1.2 on following slides):• Phase 1: From the market’s open through about 2:32 p.m., prices were
broadly declining across markets, with stock market index products sustaining losses of about 3%.
• Phase 2: From about 2:32 p.m. through about 2:41 p.m., the broad markets began to lose more ground, declining another 1-2%.
• Phase 3: Between 2:41 p.m. and 2:45:28 p.m., lasting only about four minutes or so, volume spiked upwards and the broad markets plummeted a further 5-6% to reach intra-day lows of 9-10%.
• Phase 4: From 2:45 p.m. to about 3:00 p.m., broad market indices recovered while at the same time many individual securities and ETFs experienced extreme price fluctuations and traded in a disorderly fashion at prices as low as one penny or as high as $100,000.
• Phase 5: At about 3:00 p.m., prices of most individual securities significantly recovered and trading resumed in a more orderly fashion.
Market Structure, Trading, and Liquidity Slide 20
More on the Flash Crash…
1. STOCK INDEX PRODUCTS: THE E-MINI FUTURES CONTRACT AND “SPY” EXCHANGE TRADED FUND (ETF)
2. A LOSS OF LIQUIDITY IN THE E-MINI AND “SPY” ETF MARKETS
3. AUTOMATED EXECUTION OF A LARGE SELL ORDER IN THE E-MINI FUTURES CONTRACT
4. CROSS-MARKET PROPAGATION (FUTURES TO CASH MARKETS)
5. LIQUIDITY IN THE INDIVIDUAL STOCKS THAT COMPRISE THE S&P 500 INDEX
Market Structure, Trading, and Liquidity Slide 21
Key Graphs from CFTC / SEC Flash Crash Report
Market Structure, Trading, and Liquidity Slide 22
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 23
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 24
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 25
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 26
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 27
Key Graphs from Joint Flash Crash Report (cont.)
Market Structure, Trading, and Liquidity Slide 28
Key Regulatory Topics
HFT and Market Stability (limit up/dn; breakers)
Reg NMS and Market Fragmentation
Level Playing Field: NYSE, Nasdaq, ECNs, ATS
Fairness for Retail vs. Institutional Investors
Insider Trading and Increased Surveillance
Mergers of For-Profit Exchanges / ATS firms
Impact on Corporate Issuers (e.g., WACC, prices)
Market Structure, Trading, and Liquidity Slide 29
Homework Assignment
Written deliverable (reflection paper on pre-work and in-class activities) to be graded by Prof. Pagano.
The assignment will be to discuss the concepts and experiences from this class that were most salient to your own personal investments and / or your firm’s situation.
Please limit your response to 350 to 500 words (i.e., 1-2 pages, double-spaced with 12 point font size).
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