Lecture Notes – 9 November 2012
Quote Driven Market
In this market intermediaries - market makers/dealers – quote the prices at which the public participants trade. Market makers provide a bid quote (to buy) and an offer quote (to sell).
NEXT SLIDE
The top of the slide shows the bid/offer for a stock from three different dealers. The bottom of the slide shows the “Top of the Book” the best market. Dealer A has the best bid of 40.50 and Dealer C has the best offer at 41.00.
A quote driven market allows intermediaries to provide liquidity. These may be brokers (who are agents for the actual buyers and sellers), dealers/market-makers (who are principals in the trade) and specialists – who are both brokers and dealers.
Dealers operate as principals in that they buy and sell and profit from the difference between the bid and offer. Dealers provide value to the transaction by providing capital for trading, facilitating order handing and assisting in price discovery. If your broker asks dealer A for their bid-offer he will be told 40.50-41.20. For a large order they will understand the market and be able to find the best pricing (in our example 41.00 from dealer C)
Order Driven versus Quote-Driven Markets
Overall non-intermediated order-driven markets may be less costly due to the absence of profit-seeking dealers. But the markets for many stocks are not sufficiently liquid to operate in this way. Thus one might need a dealer for such a market. The dealer provides capital, participates in price discovery and facilitates market timing.
Many stock markets operate as a hybrid.
The New York Stock Exchange
The beginnings of the NYSE is identified as May 17, 1792 when the Buttonwood agreement was signed by 24 brokers outside of 68 Wall Street under a buttonwood tree.
Throughout most of US history having a NY stock exchange listing was where large US companies would list their shares. There were strict requirements for listing:
· Pretax income of $2m
· Two year average pretax income of $2m
· Mkt value of $100m
And so on.
The NYSE is open from 9:30-4pm every day. The day starts with the opening auction. Between 7:30 and 9:30 one can place orders into the opening auction. A price is then set by the opening auction at or just after 9:30. I can place orders for the closing auction starting at 9:30am. The auction itself takes place at 4pm and sets the closing price for each stock for the day.
During the day one can place the order to be filled electronically or to have it routed to the continuous auction on the floor.
On the trading floor at the NYSE there is a special role called the designated market maker. For every stock traded on NYSE there is a DMM. This person is charged with maintaining a fair and orderly market. They facilitate price discovery during the opening and closing auctions in the market and during periods of substantial trade imbalances and high volatility. They will commit their own capital during these situations.
Nasdaq
The Nasdaq was formed in 1971 and was the world’s first electronic stock market. When it started it was simply a bulletin board that did not connect buyers and sellers but simply provided better price transparency.
Since then it has added automated trading systems and trade and volume reporting.
Nasdaq is primarily a dealer system where multiple dealers provide quotes and make trades.
Until 1987 most trading occurred via telephone. During the October crash dealers did not respond to telephone calls. As a result Nasdaq developed an electronic method for dealers to enter their trades.
In 2002 Nasdaq started a system called SuperMontage which is more of an order based system. Thus the Nasdaq has become a hybrid exchange.
Electronic Communiation Networks
Essentially an ECN is a limit order book that is widely disseminated and open for continuous trading to subscribers who may enter and access orders displayed on the ECN.
They offer: transparency, anonymity, automated service and reduced costs. This makes them work for smaller trades.
They can link into the Nasdaq marketplace via a quotation representing the ECN’s best bid and offer.
Early ECNs were Instinet (Institutional Network) now owned by Nasdaq, Archipelago (now owned by NYSE). BATS.
Larger Trades
The challenge with ECNs and exchanges comes from larger trades. Imagine the following situation. You own 1m shares of a company that ordinarily trade 100K shares a day. You have decided that you want to sell the shares and like the price you see in the market. But… you have 10 times the normal daily volume. If you simply go to your discount broker and enter a market sell order you will move the market against you.
You have several choices.
Let me first describe an iceberg order. Basically only the top of the iceberg appears in the order book. So you enter an iceberg limit order to sell 1m shares at 100 where it shows only the first 100,000 shares. Now your order looks ok and people who might have been willing to buy at 100 might step in. When the first 100,000 of your order is filled then another 100,000 order magically appears.
Two alternatives to this would be:
Find a specialist broker who handles large trades and is good at minimizing market impact. He could know the market better than you and might be able to find the buyers for your stock without advertising your position to the market.
An alternative to this would be to find a dealer to buy the entire block from you at a slight discount.
The difference between these last two is in the first you are still taking market risk –you do not know at what level the stock will eventually be sold at. In the latter you are agreeing to a discount up-front.
Crossing Networks
A last alternative for someone trying to sell a large block of stock are crossing networks. A crossing network is a network that matches buyers and sellers of larger orders using prices from elsewhere. So you want to sell your 1m shares. You could go to a crossing network and agree to trade this block at the mid-price assuming there was a willing buyer. Both buyer and seller would be happier doing this than trading in the market because they are no longer paying the bid/offer spread. They have removed the middleman.
Dark Pools
These are private crossing networks where the buyers and sellers submit a willingness to transact at an externally provided price – for example the mid-price seen in the market at a particular point in time.
A dark pool is an electronic crossing network that is designed to:
· Allow for anonymous trading
· Allow access to large liquidity pools which do not want to be known publically
o If these trades are legally obliged to be reported then this is delayed as long as possible.
The problem that one has if you are trying to sell a large block of stock is how to do so without moving the market. Dark Pools give you that option – assuming that the liquidity is available in the market.
The advantages of dark pools are:
· Non-displayed liquidity
· Anonymous trading
· Volume discovery
· Reduced market impact
The disadvantages
· No visibility
· Difficulty to interact with order flow
· No price discovery
There are lots of questions raised about dark pools.
Both dark pools and crossing networks are taking trades that would have moved the market on the exchange and trying to reduce their market impact. There is an adverse selection problem. Let’s say you want to sell a large block of stock and you put it into a dark pool. If you get filled then it means that there was a buyer willing to buy at least that amount of stock but probably more. Thus you would have been better off if that person had bought the stock in the public market before you sold than doing what you did.
There’s a transparency problem. If significant trading is happening away from the public market then there is no opportunity for the public prices to reflect these transactions.
Basics of Trading Stocks
We’ve talked a bit about orders. We are now going to talk about various issues involved in trading.
Costs of Trading
First there are some explicit costs:
· Commissions – these are generally completely negotiable – although we won’t see that with our little trades at the discount broker.
· Custodial Fees – these are the costs of holding the stock position for us. This includes the cost of handling dividends, corporate actions etc for us.
· Soft Dollars – these are implicit costs in trading. For example you might be willing to pay slightly higher commissions in order to have access to better research. If you had paid explicitly for access to the research you would call this a “hard dollar.” Generally this matters more in the institutional trading world. For example if you are a large institutional trading house then your order flow is worth a lot to a brokerage house. You might agree to send 20% of your business through a particular broker in order to have access to certain research.
o The SEC has restricted what can be paid for via soft dollars. Investment advisors also have to disclose products or services that are received through soft dollars. This method of payment is open to abuse – you would not be very happy with your investment advisor if you found out that they were using a higher cost brokerage firm in exchange for free vacations.
Implicit Costs
There are several implicit costs that we could discuss but the one worth mentioning is impact cost.
Impact Costs – this is the change in market price caused by the presence of your trade. If your trade is large relative to normal market size then it can move the market.
Timing Costs – this is the change in price between the time the that one directs a broker to execute a trade and when they actually complete the trade.
Opportunity Costs – this is the cost of securities not traded. This can be either because of the market has moved prior to the trade being executed or the market moving while the trade is being executed.
Short Selling
Imagine an investor believes a stock is overvalued but does not own the stock. He can arrange to “short” the stock. The process for doing so looks something like the following slide.
1 – The investor contacts his broker to “locate” shares for shorting. This involves the broker confirming that he has a source to borrow the shares from. A broker keeps a “Box list” which contains the inventory of shares available for shorting.
2 – Execute a short sale. The trader can now execute a short sale of the stock. It will settle on a T+3 basis.
3 – On the morning of T+3 the stock lending department will determine the actual delivery requirements for the day. If they no longer have the shares available on their box-list they will consult with other brokers etc to arrange the borrow.
It is important to note that there are times when the shares can be borrowed on T but no longer on T+3. At that point the short sale will fail. If this is the case then a “forced buy-in” will occur where the broker buys shares on behalf of the trader to settle the transaction.
4 – Cash from the short sale is used as collateral for the borrowed shares. When the trade settles the cash from the short sale is used by the broker as collateral against the borrowed stock. This cash is invested by the broker
5 – Interest is paid – A portion of the interest paid to the broker may be paid to the trader. On the other hand the trader will pay administration fees and also interest on the borrowed stock. Generally small short sellers will not earn interest but larger ones may. In addition the stock borrow fees may be large and thus the trader may have to pay these additional costs.
6 – Dividends – If the stock in the short sale pays dividends then the trader is responsible to pay these to the true owner of the stock.
Note, if at some point during the trade the lender of the stock decides they want the stock back (for example they chose to sell the stock), then the broker will have to arrange another borrow. If this is not possible to do then they will notify the trader that the position must be covered. Generally they may buy-in the stock automatically.
Now let’s do a simple example. If you view that a particular stock is over-priced say at $100 you can instruct your broker to sell 100 shares of stock X and borrow 100 shares of stock X from someone else. When the sale of the stock completes the proceeds are not given to you but instead retained by the broker as you are now short 100 shares of X.
Let’s say 1 week later you are proven correct and the share price of X falls to 75. You can now arrange to buy 100 shares of X and ignoring commissions you will make
$100*100 – $100*75 = $2,500
Now let’s look at the opposite situation. If the share price of X rises to 150 then you might arrange to buy back your short.
Now
$100*100 - $100*150 = -$5,000
and you have lost money. In fact you have quite a bit more downside than you do upside. If the company goes bankrupt and trades down to zero you make $10,000. If the stock triples in value tomorrow then you lose $20,000.
Basic Functioning of the Stock Market
Unlike the foreign exchange market which is very much an OTC market with minimal regulations – the stock market is highly regulated.
Price and Quote Reporting
There is an organization called the Consolidated Tape Association – this manages two systems:
· CTS – This system provides last sale and trade data for issues listed on various US stock exchanges
· CQS – This system provides quotation information for issues listed on various listed stock exchanges
o They calculate a National Best Bid and Offer based on price and size.
Clearance and Settlement
After a stock trade is completed, the delivery of shares by the seller and payment of cash by the buyer is handled through the Depository Trust and Clearing Corporation (DTCC). Generally settlement is on a T+3 business day basis.
4