FIN11 Trading and Market Microstructure Autumn 2021 - Lecturer: Klaus R. Schenk-Hoppé

FIN11

    Trading and
Market Microstructure

      Autumn 2021
Lecturer: Klaus R. Schenk-Hoppé

Session 7

 Dealers

Themes

                        Dealers
                       What & Why

                     Market making
                     Profits & Risks

    Wake-up video: Wall Street in 1920s (my drive) 1.5 minutes
●
    "Behind the Ticker Tape" (1957) 10 minutes
     https://www.youtube.com/watch?v=tEbZswUEnsU

Questions

●
    NYSE moved from twice-daily auctions to
    […............] trading in 1870s
       –   How?
       –   Why?

●
    How can one offer immediacy?
       –   Solution LOB
       –   Solution D

Dealers

●
    Make continuous markets
        –   Buy when others want to sell
        –   Sell when others want to buy

●
    Liquidity providers
●
    Profit-motivated traders
        –   Try to buy low & sell high

Dealers

are
●
    passive traders
●
    high-frequency traders

do not specialize in information gathering
●
    know little about
        –   fundamental values
        –   with whom they trade

Quote-driven dealer markets

  Dealer                  Public
   sells                  seller

    10:00                  10:10                 10:20

   Public                 Dealer
   buyer                  Buys

Dealers provide immediacy which indirectly brings buyers
                  and sellers together

Dealers' business model
●
    Revenue generators
       –   Bid/ask spread (trading order flow)
       –   Commissions
●
    Cost generators
       –   Inventory cost
               ●
                   carrying unbalanced inventory
       –   Information cost
               ●
                   trading with better informed participants

Example: Quote-driven market

Option market example

        http://www.six-structured-products.com/en/latest-news/marktuebersicht

                              https://www.cmegroup.com
                              /

https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude_contract_specifications.htm
l

The inside spread in a
          dealership market
100.8

100.7

100.6

100.5

100.4                                                 Best offer (Dave)
                       Inside spread
100.3                                                 Best bid (Denise)
                                             Denise
100.2
                                       Dan
100.1
                           Dinah
100.0
               Derek
 99.9
        Dave

Fact

  Many market venues rely on
dealers or specialists to improve
        market resilience

●
    NYSE has Designated Market Makers
    (formerly Specialists)
●
    NASDAQ has Dealers
●
    LSE has Market Makers

Stressful market conditions

 ●
     Bear markets
 ●
     Important news
 ●
     Derivative expiration dates
 ●
     Momentum trading (e.g. stop orders)
 ●
     Daily openings
 ●
     Large orders
     (here dealers become block facilitators)

A Stressful Market Situation

Question

Are dealers on the
             sell side or buy side ?

Dealers vs brokers
●
    Dealers trade with their customers
    Brokers trade on behalf of their customers
        –   Dealers are principals
        –   Brokers are agents

●
    Suppose you want to buy an option contract
        –   Retail clients trade with a dealer
             through their broker
        –   Is there a potential problem?

What makes a
     good,
i.e. profitable
    dealer?

What makes a profitable dealer?
●
    Inventory control
●
    Trading the order flow carefully
●
    Ability to hide/disguise large positions
●
    Knowledge of customers (source of the order flow)
     important in practice
         –   Customer relationships, Quote matching
●
    Receiving a large percentage of the order flow
         –   Preferencing
●
    Maker-taker pricing (exchanges aim to attract liq.)

Dealers' two main challenges

 ●
     How to handle inventory

 ●
     How to set the spread

Inventory management (FX)

Source: Bjønnes & Rime, JFE (2005)
Dealer behavior and trading systems in foreign exchange markets

Dealers' inventories
●
    Inventories: positions dealer
        has on the securities they trade
    Long/short positions possible
●
    Target inventory: position dealer
       wants to hold

●
    Dealer’s inventory is in balance when it is
    near the dealer’s target levels
    (out of balance otherwise)

Inventory control

 I n c r e a s e in v e n t o r y         D e c r e a s e in v e n to r y
 Inc re a s e p ric e s (b id & a s k )   D e c re a s e pric e s (b id & a s k )
 Inc re a s e b id s iz e                 R e d uc e bid s iz e
 R e d u c e a s k s iz e                 In c re a s e a s k s iz e
 T a k e oth e r de a le r's off e r      H it othe r d e a le r's bid

Alternative (if available): Hedge your position

Quotes and inventory positions

Inventory risk (unpleasant!)
●
    Diversifiable (no systematic loss) if
        –   future price changes independent
              of inventory imbalances
        –   deal in many instruments

●
    Adverse selection (systematic loss) if
        –   future price changes inversely related to
              inventory imbalances
        –   dealers trade with informed traders

Adverse selection risk
●
    Informed traders
        –   buy when they think that prices will rise
        –   sell when they think that prices will fall
●
    If dealer trades with informed trader
     prices tend to fall (rise) after dealer bought (sold)
        –   Prices tend to fall when dealer is long, and
             rise when short
        –   Realized spreads are often negative

●
    What can be done?

Dealer's response to adverse selection

If you believe you just traded with informed trader
        –   Adjust prices and sizes to
                 ●
                     Discourage more trade in same direction
                 ●
                     Encourage trade in opposite direction
        –   Unload your unbalanced position on another
             dealer:
             'Shares sold to a market maker are still for sale'
        –   Hedge your unbalanced position
        –   Whatever you do, it must be done quickly

●
    Ex ante, dealers set their bid/ask spreads to
    protect themselves against informed traders

Trading with dealers

Recap: Market maker services
●
    Immediacy
        –   Rapid execution of customer orders
●
    Supplemental liquidity
        –   But only temporary:
                ●
                    "Shares sold to a market maker are still for sale”
●
    Price discovery
        –   Market makers try to predict what sell side will do
●
    Price improvement, due to
        –   Customer relationship
        –   Inventory management
        –   Buy/sell pressure

Buy-side trading in dealer markets
●
    Directly with dealers
        –   Ask for two-sided quote before revealing
             whether you want to buy or sell. WHY?
●
    Through a broker
        –   Brokers know inside spread
        –   May obtain price improvement
                ●
                    Brokers build reputations for not representing
                     informed clients
        –   But we may not get best quoted bid or ask:
             due to preference arrangements between
             brokers and dealers
                ●
                    Dealers pay for order flow

Question

          In FX (foreign exchange) markets
            why is/was there so much trade
                     between dealers
                                 ?

●
    Decentralized (in 1995, 85% was inter-dealer)
●
    Large sizes (distribution)

Bid/ask spread

Bid/ask spreads
●
    Spread = price of immediacy
        –   Market orders pay...
        –   to dealers and limit orders

●
    Most important factor in
        –   order placement decision
              (market vs limit orders)
●
    Most important factor in
        –   dealer’s decision on liquidity provision

Dealer spreads
●
    Monopolistic dealer sets spread s.t.
     max volume(spread) x (spread-costs)
●
    But dealers face tough competition from
       –   other dealers
       –   limit order traders
●
    In competitive dealer market
           spread = cost
    cost = Transaction costs
                 + Adverse selection costs

Spread/cost components

●
    Transaction cost component
       –   Running costs of doing business,
            risk premium, plus any monopoly profits
       –   Responsible for the bid-ask bounce
       –   Transitory spread component

●
    Adverse selection component
       –   Compensate dealers for
                        losses to informed traders
       –   Permanent spread component

Adverse selection component of spread
●
    Customer asks dealer (you!) for a two-way quote
        –   You say: “Bid 50,000@68.20, Offer 50,000@68.50”
a)Customer says: “I buy 50,000”
        –   Do you learn anything?
        –   How much does the customer think the stock is worth?
        –   How did the customer arrive at her value estimate?
        –   Did you ask too little?
b)Customer says: “I sell 50,000”
        –   Did you bid too much?

●
    When you make your (two-sided) quote, you must
    anticipate what you will learn about the market
    when the customer says “buy” or “sell”

Adverse selection & uninformed traders
When uninformed traders use limit orders
        (a) If informed traders on same side
                ●
                  price moves away from the uninformed
                   trader
                ●
                  no execution; regrets not trading
        (b) If informed traders on other side
                ●
                  uninformed trader gets execution
                ●
                  price moves against him; regrets trading

●
    When uninformed traders use market orders
        –   pay large spreads (due to informed trading)

2 views on
    adverse selection component

Information perspective
●
    Difference in value estimates that dealers
    make conditional on the next trader being
    a buyer or a seller

Accounting perspective
●
    Portion of spread that dealers must quote
    to recover from uninformed traders
    what they lose to informed traders

The enemy of liquidity

Informed trading

The more trades are informed, the more
money you lose

Toxicity of order flow
The PIN measure (technical)
    A highly simplified version of 1996 JF paper
    by Easley, Kiefer, O'Hara, Paperman

●
    Market maker posts bid B and ask A, B < A
●
    There are uninformed traders (your gain)
    and informed traders (your loss)
●
    Arrive with probabilities u and i
●
    News arrival: none, good, bad with prob 1-a, a/2, a/2
●
    Price: today S(0) = S
           tomorrow S(1) = S, SG, or SB, with SG > S >SB

Problem: Set A and B
    Break even condition      (perfect competition)

●
    Expected price tomorrow

     ES (1)=(1−a)∗S+0.5∗a∗SG+0.5∗a∗SB

●
    Expected profit from buying at bid B

           u∗[ ES (1)−B ]+i∗[SB−B ]=0
                   (gain)           (loss)
●
    Selling at ask A

           u∗[ A−ES (1)]+i∗[ A−SG]=0

Calculate bid-ask spread

●
    Solve the two profit equations
●
    Calculate A – B
                     i
               A−B=     [SG−SB]
                    i+u
●
    The more likely arrival of informed traders,
    the wider the spread
●
    Estimate empirically to explain market under
    stress
●
    Volume matter as well VPIN

VPIN in practice

●
    Applied to 2010 flash crash
    and to study daily mini flash crashes
●
    Proposed to regulators and exchanges
●
    Toxicity of order flow
●
    But thorny estimation issues

    O'Hara is on
    CFTC-SEC Emerging Regulatory Issues Task
    Force (the “flash crash” committee)

Determinants of
        equilibrium spreads
in continuous order-driven markets
●
    Information asymmetry among traders (+++)
●
    Volatility (++)
●
    Value of trader time (+)
●
    Trader risk aversion (+)
●
    Time to cancel limit orders (++)
●
    Limit order management costs (+)
●
    Differential commission between limit and market
    orders (++)
         –   Exchanges move to Maker-Taker model

Break