Market Microstructure

December 2, 2016
Tarun Chordia of Emory University, Amit Goyal of University of Lausanne, Joel Hasbrouck of New York University, Research Associate Bruce Lehmann of University of California at San Diego, Gideon Saar of Cornell University, and Avanidhar Subrahmanyam of University of California at Los Angeles, Organizers

Lin William Cong and Xun Xu, University of Chicago

Rise of Factor Investing: Asset Prices, Informational Efficiency, and Security Design

Cong and Xu model financial innovations such as exchange-traded funds, smart beta products, and many index-based vehicles as composite securities that facilitate trading common factors in assets' liquidation values. Through accessing a larger basket of assets in endogenously-chosen proportions, they can benefit both informed and liquidity traders. Optimal designs feature selecting liquid and representative assets, and attracts all factor investors regardless of their informedness or liquidity needs. Consistent with empirical findings, introducing composite securities leads to higher price variability and co-movements, larger trading costs and synchronicity, and lower asset-specific but higher factor information in prices, especially for illiquid assets. Transparency of composite security trading, distinction between composite bundles and derivatives, and endogenous information acquisition also significantly affect prices and security design.

Paolo Pasquariello, University of Michigan

Agency Costs and Strategic Speculation in the U.S. Stock Market

This study shows theoretically and empirically that a firm's agency problems may affect its stock liquidity. Pasquariello postulates that less uncertainty about suboptimal managerial effort may enhance liquidity provision - by lowering dealers' perceived adverse selection risk from trading with better-informed speculators. Consistent with Pasquariello's theory, he finds that the staggered adoption of anti-takeover provisions across U.S. states in the 1980s and 1990s - a plausibly exogenous shock reducing perceived effort uncertainty by unambiguously facilitating managerial agency - improves the stock liquidity of affected firms relative to peer firms. This evidence suggests that firm-level agency considerations play a nontrivial role for the process of price formation in financial markets.

Jennifer Conrad, University of North Carolina at Chapel Hill, and Sunil Wahal, Arizona State University

The Term Structure of Liquidity Provision

Conrad and Wahal examine the term structure of liquidity provision in all stocks from 100 milliseconds to 600 seconds after each trade for 2000-2015. At a one second horizon, the aggregate price of liquidity provision, net of losses to information, fell from 17 basis points of total dollar volume in 2000 to 1.5 basis points in 2015. Regulatory changes, technological shocks, and changes in the industrial organization of markets are associated with declines in the price of liquidity provision, and with changes in the term structure. Over the 16-year period, the slope of the term structure is increasingly steep, consistent with intense non-price (i.e. speed) competition. The term structure and profitability of market-making is closely tied to market, rather than idiosyncratic, risk. This is consistent with electronic market makers managing liquidity provision in large well-diversified portfolios of securities.

Andriy Shkilko and Konstantin Sokolov, Wilfrid Laurier University

Every Cloud has a Silver Lining: Fast Trading, Microwave Connectivity and Trading Costs

In modern markets, trading firms spend generously to gain a speed advantage over their rivals. The marketplace that results from this rivalry is characterized by speed differentials, whereby some traders are faster than others. Is such a marketplace optimal? To answer this question, Shkilko and Sokolov study a series of exogenous weather-related episodes that temporarily remove speed advantages of the fastest traders by disrupting their microwave networks. During these episodes, adverse selection declines accompanied by improved liquidity and reduced volatility. Liquidity improvement is larger than the decline in adverse selection consistent with the emergence of latent liquidity and enhanced competition among liquidity suppliers. The results are confirmed in an event-study setting, whereby a new business model adopted by one of the technology providers reduces speed differentials among traders, resulting in liquidity improvements.

Haoming Chen, Australian Securities and Investments Commission; Sean Foley, University of Sydney; Michael Goldstein, Babson College; Thomas Ruf, University of New South Wales

The Value of a Millisecond: Harnessing Information in Fast, Fragmented Markets

Chen, Foley, Goldstein, and Ruf examine the introduction of a speed bump by an existing exchange, which provides certain participants with guaranteed speed advantages. A selective order processing delay for marketable orders on TSX Alpha allows low-latency liquidity providers to avoid adverse selection through their ability to react to activity on other venues. These changes increase profits for liquidity providers on TSX Alpha but negatively impact aggregate liquidity: market-wide costs for liquidity demanders increase, with liquidity suppliers' profits reduced across remaining venues. The researchers' findings have implications for the speed bump debate in the United States, speed differentials more generally, as well as the regulation of market linkages across fragmented trading venues.

Katya Malinova and Andreas Park, University of Toronto

Market Design with Blockchain Technology

Blockchain or, more generally, distributed ledger technology allows to create a decentralized digital ledger of transactions and to share it among a network of computers. In this paper, Malinova and Park argue that the implementation of this technology in financial markets offers investors new options for managing the degree of transparency of their holdings and their trading intentions. They first identify two intrinsic features of a distributed ledger that impact the availability of these new options, namely the mapping between identifiers and end-investors and the degree of transparency of the ledger, and they then examine how the implementation design of these critical features affects investor trading behavior, trading costs, and investor welfare, in a theoretical model of intermediated and peer-to-peer trading. The researchers find that, despite the risk of front-running, the most transparent setting yields the highest investor welfare. In the absence of full transparency, for low levels of liquidity in the intermediated market and low costs for transaction validation, welfare is highest if investors are required to concentrate their holdings under single identifiers.

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