Market Microstructure Meeting

December 16, 2011
Tarun Chordia and Amit Goyal, Emory University; Charles Jones, Columbia Business School; and Bruce Lehmann and Avanidhar Subrahmanyam, University of California, San Diego, Organizers

Albert Menkveld, VU University Amsterdam
High Frequency Trading and the New-Market Makers

Menkveld links the recent fragmentation in equity trading to high-frequency traders (HFTs). He shows how the success of a new market, Chi-X, critically depends on the participation of a large HFT who acts as a modern market-maker. The HFT, in turn, benefits from low fees in the entrant market, but also uses the incumbent market Euronext to offload nonzero positions. It trades, on average, 1397 times per stock per day in Dutch index stocks. The gross profit per trade is 0.88 euro which is the result of a 1.55 euro profit on the spread net of fees and a 0.68 euro "positioning" loss. This loss decomposes into a 0.45 euro profit on positions of less than five seconds, but a loss of 1.13 euro on longer duration positions. The realized maximum capital committed because of margin requirements is 2.052 million euro per stock which implies an annualized Sharpe ratio of 9.35.

Paolo Pasquariello, University of Michigan, and Clara Vega, Federal Reserve Board
Government Intervention and Strategic Trading in the U.S. Treasury Market

Pasquariello and Vega study the impact of outright (that is, permanent) Open Market Operations (POMOs) by the Federal Reserve Bank of New York (FRBNY) on the microstructure of the secondary U.S. Treasury market. POMOs are trades in U.S. Treasury securities aimed at accomplishing the Federal Reserve's target level of the federal funds rate. This analysis is motivated by a parsimonious model of speculative trading in the presence of a stylized Central Bank targeting the price of the traded asset. Contrary to previous studies of government intervention in financial markets, the authors here show that such trading activity improves equilibrium market liquidity, and that the magnitude of this effect is sensitive to the market's information environment. They test these implications by analyzing a novel sample of intraday U.S. Treasury bond price quotes (from BrokerTec) and a proprietary dataset of all POMOs conducted by the FRBNY between 2001 and 2007. The evidence suggests that 1) bid-ask spreads of on-the-run Treasury securities decline on days when POMOs are executed; and 2) POMOs' positive liquidity externalities are increasing in proxies for information heterogeneity among speculators, fundamental volatility, and policy uncertainty, consistent with our model.

Zhiguo He, University of Chicago, and Konstantin Milbradt, MIT
Endogenous Liquidity and Defaultable Bonds

He and Milbradt study the liquidity of defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond's endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default and investment decisions interact with the endogenous secondary market liquidity via the rollover channel. A default/investment-liquidity loop arises: earlier endogenous default worsens a bond's secondary market liquidity, which amplifies equity holders' rollover losses, which in turn leads to earlier endogenous default. Thus, this model characterizes the full inter-dependence between liquidity premium and default premium in understanding credit spreads for corporate bonds. The authors also study the optimal maturity implied by the model, and an extension where worsening secondary market liquidity feeds back to endogenous underinvestment.

James E. Upson, University of Texas at El Paso, and Thomas H. McInish, University of Memphis
Strategic Liquidity Supply in a Market with Fast and Slow Traders

Modern equity markets have both fast traders such as dealers, market makers, and High Frequency Traders and slow traders, such as retail clients. Upson and McInish model and show empirically that latency differences allow fast liquidity suppliers to pick off slow liquidity demanders at prices inferior to the NBBO. This trading strategy is highly profitable for the fast traders. The authors estimate that the fast traders earn more than $281 million per year at the expense of the slow traders. Investigating the decrease in NYSE latency in March 2010, they also show that when markets become faster, execution quality improves for fast liquidity demanders, but decreases for slow liquidity demanders.

Lawrence Harris, University of Southern California

The Homogenization of U.S. Equity Trading

NASDAQ stocks once traded in quote-driven dealer markets while listed stocks traded in order-driven auctions on exchange floors stabilized by exchange specialists. These market structure differences caused higher volumes and transitory volatility for NASDAQ stocks. Following the adoption of certain SEC policies and the growth of electronic trading, all stocks now trade in similar, albeit diverse systems. Harris provides empirical evidence of the homogenization of U.S. equity trading by showing that volumes and transitory volatility no longer differ by primary listing market. Secondary results indicate that specialists at listed exchanges have stopped providing measurable price stabilization services. The results have important public policy implications because they indicate that issuers no longer have meaningful control over how their stocks trade.

Maureen O'Hara, Cornell University, and Mao Ye and Chen Yao, University of Illinois
What's Not There: The Odd-Lot Bias in TAQ Data

O'Hara, Yao, and Ye investigate the systematic bias that arises from the exclusion of trades for less than 100 shares from TAQ data. In their sample, the median number of missing trades per stock is 19 percent, but for some stocks missing trades are as high as 66 percent of total transactions. Missing trades are more pervasive for stocks with higher prices, lower liquidity, higher levels of information asymmetry and when volatility is low. The authors show that odd lot trades contribute 30 percent of price discovery and trades of 100 shares contribute another 50 percent, consistent with informed traders splitting orders into odd-lots and smaller trade sizes. The truncation of odd-lot trades leads to a significant bias for empirical measures such as order imbalance, challenges the literature using trade size to proxy individual trades, and biases measures of individual sentiment. Because odd-lot trades are more likely to arise from high frequency traders, the authors argue their exclusion from TAQ and the consolidated tape raises important regulatory issues.

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