Microstructure of World Trading Markets: A Special Issue of the Journal of Financial Services Research

152 Pages·1993·9.091 MB·English

by  Hans R. Stoll (auth.), Hans R. Stoll (eds.)

MICROSTRUCTURE OF
WORLD TRADING MARKETS
A Special Issue of the Journal of
Financial Services Research
edited by
Hans R. StoU
Reprinted from the Journal of Financial Services Research
VoI. 6, No. 4 (1993)
"
~.
SPRINGER SCIENCE+BUSINESS MEDIA, LLC
Library of Congress Cataloglng-in-Publication Data
Microstructure of wor1d trading markets : a special issue of the
Journal of tinancial services research / edited by Hans R. Stoll.
p. cm.
"Reprinted from the Journal of tinancial services research, volume
6, number 4 (1993)."
lncludes bibliographical references.
ISBN 978-94-010-4965-8 ISBN 978-94-011-2180-4 (eBook)
DOI 10.1007/978-94-011-2180-4
1. Stock-exchange--Data processing. 2. Securities industry--Data
processing. 3. Program trading (Securities) 1. Stoll, Hans R.
II. Journal of tinancial services research.
HG4515.5.M53 1993
332.64'0285--dc20 92-43846
CIP
Copyright © 1993 by Springer Science+Business Media New York
Originally published by Kluwer Academic Publishers. in 1993
Softcover reprint ofthe hardcover Ist edition 1993
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmiUed in any form or by any means, mechanical, photo-copying, record ing,
or otherwise, without the prior written permission of the publisher, Springer Science+
Business Media, LLC.
Printed on acid-free paper.
JOURNALOFFINANCIALSERVICES RESEARCH
Vol. 6, No.4, January 1993
MICROSTRUCTURE OFWORLD TRADING MARKETS
A Special 1ssue oftheJournal ofFinancial SelVices Research
Introduction Hans R. Stoll
AutomatingthePriceDiscoveryProcess:Some InternationalComparisons
and Regulatory Implications. . . . . . . . . . . . . . . . . . . . . . . . . .. Ian Domowitz 5
Automated SecuritiesTrading. . . . . . . . . . . . . . . Brandon Becker, EugeneLopez,
Victoria Berberi-Doumar, RichardCohn, andAldenAdkins 27
An EmpiricalExaminationofMarket MakerProfitson theLondon
Stock Exchange. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . AnthonyNeuberger 43
AutomatingGermanEquityTrading: Bid-AskSpreadson
CompetingSystems Hartmut SchmidtandPeterIversen 73
The Market Spread, Limit Orders, and Options. . . . . . . . . . . . .. Henk Berkman 99
TheSettlementDayEffectinthe French
Bourse Michel CrouhyandDan Calai 117
TheMicrostructureofAsianEquity
Markets S. Chon RheeandRosita P. Chang 137
JournalofFinancialSelVicesResearch301-303(1992)
©1992KluwerAcademicPublishers
Microstructure ofWorld Trading Markets
HANSR.STOLL
TheAnneMarieandThomasB. WalkerProfessorofFinance, Owen GraduateSchoolofManagement,
Vanderbilt University, Nashville, Tennessee37203
Automation, high-speedcommunication, electronicmarkets, and the increasedsophis
ticationofinvestorsaredramaticallychangingfinancialmarketsandaregreatlylessening
theeffectivedistanceamongwidelyseparatedworld tradingmarkets.Thestudyofmar
ketmicrostructure, heretoforerestricted primarilytoU.S. markets,israpidlyexpanding
toforeign markets. This reflects the developmentofforeign marketsand the increased
academicandpolicyinterestin theproperfunctioningoffinancial markets. In 1992asa
major U.S. financial institution, the New York Stock Exchange, celebrates its 200th
anniversary, attentionin the U.S. isincreasinglyfocused onthechallengesfrom foreign
markets. RapideconomicdevelopmentinEuropeand in theFarEast haveputforeign
equitymarketsonamoreequalfootingwithU.S.markets.Atthesametime,newfutures
andoptionsmarketshavebeenestablishedinmostofthemajorforeignfinancialcenters.
U.S.financialfirmshaveexpandedintothesemarketsatthesametimethatforeignfirms
haveexpandedintoU.S. markets.Whiletradinginequitiescontinuestooccurprimarily
incompanies'homecountries,cross-bordertradingofcommonstocksislikelytoincrease
inthecomingyears.Similarly,futuresandoptionscontractsarelikelytoattractincreased
cross-bordertrading. Theseprospectsrequirea betterunderstandingofthe natureand
functioningofforeign tradingmarkets.
The articles in this volume address various aspects of the microstructure of world
trading markets and provide scientific evidence on the functioning ofspecific foreign
markets. They were selected, after review, from those presented at a Conference on
World Trading Markets held in April 1992at the Owen Graduate School ofManage
ment, VanderbiltUniversity.! TheconferencewassponsoredbyVanderbilt'sFinancial
MarketsResearchCenterwithaspecialgrantfrom theNewYorkStockExchange.
Inthefirstarticle,IanDomowitzexaminestheextenttowhichpricediscoveryinworld
tradingmarketsisautomated.Henotesthat76percentofautomatedtradingsystemsfor
futures and options have come on line after 1987, and most ofthese new markets are
locatedinEuropeorthePacificregion.Automatedtradingofstockshasalongerhistory,
mostofitconfinedtoNorthAmerica,butrapidautomationofequitytradingisoccurring,
particularlyabroad. Domowitzproposesseven levelsofautomated pricediscoveryand
classifies46automatedtradeexecutionsystems.Henotesthatautomatedtradeexecution
givesrise tonewregulatory issues.
Brandon Becker and his colleagues provide perspective on appropriate regulatory
policy when markets become ever more tightly linked by automation and high-speed
302
HANSR.STOLL
communications. New institutionscompetewithestablished markets, and trading need
no longer take place on physical exchange floors. They point to the important role of
markettransparencyinmitigatingpossibleadverseeffectsofmarketfragmentationwhile
makingpossiblethebenefitsofincreasedcompetitionamongdifferentmarketcenters.
AnthonyNeubergerprovidesa thoughtful,comprehensive, andempiricallytractable
modelofdealerbehavior.Themodelincorporatesthethreeimportantfactorsthataffect
adealer'spricingstrategy: (1)orderprocessingcosts,suchaswagesandcomputercosts,
(2)theriskassociatedwithholdinginventory,and(3)theeffectondealersoftradingwith
investorsthatarebetterinformed than thedealer. The model istested usingdataonall
transactionsin 14Britishcompaniestraded intheLondonStockExchangeintheperiod
September1987toFebruary1988.Thedata indicatewhethermarketmakersasagroup
arebuyersorsellersofthesecurity.Thearticledemonstratesthatmarket-makerprofits
aremuchlessthanwhatisimpliedbythe bid-askspread.
Germanyhasbeenalaggardinmodernizingandautomatingitstradingmarkets.While
clearingand settlement have alwaysbeenveryefficient, the processoftrading hasonly
recentlyundergonemodernization. Schmidtand Iversenexaminethebid-askspreadsin
two competing German equity trading systems: MATIS (MakJer-Tele-Informations
System) and IBIS (Inter-Banken-Informations-System). The article also contrasts
spreads in these systems to spreads for German stocks traded on the London Stock
Exchange'sSEAQInternationalSystem.WhilethemostrecentversionofIBIS,IBISII,
asystemsupportedbythe German banks, appearstobegaininggroundwith respect to
MATIS, a system developed by the German makJerorspecialist, Schmidt and Iversen
find that spreads on the IBIS system are higher than on the MATIS system. They
concludetheirarticlewithattemptstoexplainthesedifferencesinspreads.
Indealermarkets,likeLondon'sSEAQsystemortheUnitedStatesNASDAQsystem,
bid-askquotesare madestrictlybydealers, butincontinuousauction markets, like the
New York Stock Exchange and other markets, bid-ask quotes are placed either by
professionaldealersorbypubliclimitorders.HenkBerkmananalyzesthefactorsdeter
miningthebid-askspreadofstockoptionstradedontheEuropeanOptionsExchangein
Amsterdam,whichisacontinuousauctionmarket.Heshowsthatgreaterparticipationby
limitordersnarrowsthespread.Hespeculatesthatthenarrowingofthespreadisdueto
theslownessoflimitorderstobe adjustedasunderlyingmarket priceschange.
Markets differ in theirclearingand settlement proceduresand, as Crouhyand Galai
show,suchdifferencescan have importanteffectson theshort-runbehaviorofreturns.
While tradingofequitieson the French Bourse has been automated since 1986,settle
mentofactivelytradedstocksstilloccursatmonth-end.Thisinstitutionalfeature allows
buyersofstocktopostponepaymentanddelaysthespeedwithwhichsellersreceivetheir
funds. Crouhy and Galai show that stock pricesfully adjust for this settlement feature,
with theeffect that returns are abnormally high between the last dayofonesettlement
month and thefirst dayofthe nextsettlement month. Crouhy and Galai pointout that
analysts of the microstructure of French stock markets need to take account of the
nonstationarityofreturns introducedbythissettlementfeature.
Today'smostrapidlydevelopingeconomiesaresituatedonthePacificrim.LikeJapan
before them, these economies-Hong Kong, Korea, Malaysia, Singapore,Taiwan, and
Thailand-have grown dramatically, and they boast some of the strongest emerging
2
MICROSTRUCTUREOFWORLDTRADINGMARKETS 303
equity markets. Rhee and Chang provide an overview ofthese markets that includes a
discussionoftheirsize,theirtradingprocedures,theirclearingsystems,theirregulatory
policyandothermatters.Theadvancesinthesemarketshavebeensubstantialandtheir
role in theworldfinancial marketsislikelytobecomemoreimportant.
Thearticlesinthisvolumereflectthegrowinginterestofpolicymakersandacademics
in the functioning ofworld financial markets. Given the rapid developments in foreign
markets, it isan interest and an areaofacademic inquiry that is likely to expand in the
yearstocome.
Note
I. The assistanceofFranklin Edwards, an editorofthisjournal, in selectingand reviewingthe articles is
gratefullyacknowledged.
3
JournalofFinancialServicesResearch305-326(1992)
© 1992KluwerAcademicPublishers
Automating the Price Discovery Process:
Some International Comparisons
and Regulatory Implications
IANDOMOWITZ
DepartmentofEconomics, Northwestern University, Evanston, /L60208
Abstract
Automatedtradeexecutionsystemsareexaminedwithrespecttothedegreetowhichtheyautomatetheprice
discoveryprocess.Sevenlevelsofautomationofpricediscoveryare identified,and47systemsareclassified
accordingtothesecriteria.Systemsoperatingatvariouslevelsofautomationarecomparedwithrespecttoage,
geographicallocation,andtypeofsecuritiestraded.Informationprovidedtomarketparticipantsandasymme
triesofinformationbetweentraderswithdirectaccesstotheautomatedmarketandoutsideinvestorsalsoare
examined. It isfound, for example, that the degree ofasymmetric information increaseswith the level of
automationofpricediscovery.Thepotentialfortradingabusesrelatedtoprearrangedtrading,noncompetitive
execution,andtradingaheadofcustomersisanalyzedforeachlevelofautomation.Certainlevelsofautomation
widentheopportunitiesfortradingabusesinsomerespects,butmaynarrowtheminothers.
Introduction
Computerized trade execution is the final step in the automation of financial trading
marketoperations. An automated marketstructureconsistsofacommunicationstech
nologyforpassingmessagesbetweentradersandasetofrulesthatrestrictmessagetypes
andgovernthemeansbywhichagivensetofmessagestranslatesintotransactions.These
rules are programmed into an automated trade execution algorithm, which determines
transactionspricesandquantityallocations.
Enabling this process of price discovery is a basic function of any trading market
mechanism.Interestin theautomationofthepricediscoveryprocessismanifestinboth
thelongrun listofcomputerizedtradesystemscurrentlyinoperationand the degreeof
internationalregulatoryactivitysurroundingtheidea.Tables1and2containinformation
on 47 automated trade execution systems for futures and options and for stocks and
bonds,respectively,operatingasformal exchanges.! Atleastfive internationalorganiza
tions currently are addressing issues relating to the automation ofthe trade execution
process.2
Financialsupportfrom theNationalScienceFoundation,theCenterforUrbanAffairsandPolicyResearch,
NorthwesternUniversity,andtheInternationalMonetaryFundisgratefullyacknowledged.IthankRubenLee,
HansStoll,andtheparticipantsatthe InternationalTradingMarketsConference,VanderbiltUniversity,for
usefulcommentsandsuggestions.
306
IANDOMOWITZ
Table1. Automatedfuturesandoptionsexchanges
System Numberof Levelof
(exchange) Date Hours securities/products Country automation
GLOBEX(CME) 1992 Night 100(potential) USA 4,5,7
ATS/2(IFOX) 1989 Day 4 Ireland 5
FAST(LFOX) 1990 Day 4 UK 5
APT(LIFFE) 1989 Night I UK 4
ATS(NZFOE) 1985 Night II NewZealand 5
SYCOM(SFE) 1989 Night 5 Australia 4,5
FACTS(TIFFE) 1989 Day 4 Japan 5
AUTOM(PHLX) 1990 Day 37 USA I
DTB(GFOE) 1990 Day 19 Germany 5
S-MART(MEFF) 1990 Day 2 Spain 5
MOFEX(MOFF) 1990 Day 2 Spain 5
SOFFEX(SOFFE) 1988 Day 14 Switzerland 4,5,3(blocks)
CORES-F(TSE) 1988 Day I Japan 5
CORES-O(TSE) 1989 Day I Japan 5
SITS(OSE) 1988 Day 2 Japan 5
OTS(OSE) 1989 Day I Japan 5
TGE(TGE) 1988 Day 6 Japan 6
RAES(CBOE) 1985 Day 180 USA I
AUTO-EX(AMEX) 1985 Day Allequityoptions USA I
POETS(PSE) 1991 Day Listedequityoptions USA I
SOM(SOM) 1985 Day 13 Sweden 5
Themostrecentgrowthinautomatedexecutionisinthefuturesandoptionsmarkets,
where76percentoftheautomatedsystemshavecomeonlineafter1987oraresoontobe
operational.Thevastmajorityofthesenewerautomatedfuturesandoptionsmarketsare
located in Europe orthe Pacific region. In contrast, about 56 percent ofstock systems
were built prior to 1988, and the preponderance ofthese are in North America. Most
automated systemsoperate during regular trading hours, although automation has the
potential to enable 24-hour trading. Only two stock systems and four futures/options
systemsoperateduringsome portionofthenight.
A complete discussion ofautomated trade execution systems involves order execution
priorityrules,the preciseform ofthetrade matchingalgorithm,andadescriptionofalter
nativeinformationtransmissionanddisplaymechanisms.3Thegoalofthisarticleismore
modest.Thepurposehereistodiscusssystemsintermsofdegreetowhichtheyautomate
the pricediscoveryprocess.Tradematchingsystemsthat use pricestakenfrom another
marketfor thepurposeofexecutingtransactionsprovide noautomationofpricediscov
ery,forexample. Othersystemsembodyalgorithmsthatcompute transaction pricesbased
onorderflow andmarketconditions,completelyendogenizingthe discoveryprocess.
6
AUTOMATINGTHEPRICEDISCOVERYPROCESS 307
Table2. Automatedstockandbondexchanges
System Levelof
(exchange) Date Hours Securities Country automation
SEATS(ASX) 1987 Day AllASXlistedstocks Australia 5
CAC(Paris) 1986 Day Allstocks France 5,3(blocks)
Mostbonds
IBIS(FSE) 1991 Day 30stocks,29bonds Germany 4,5
GTB(Milan) 1991 Day Moststocks(phasedin) Italy 5
MORRE(ME) 1990 Day Allstocks Quebec 1
SIB(SSE)! 1991 Day 116stocks Spain 5
SAEF(LSE) 1989 Day LSElistedstocks UK 1
BEACON(BSE) 1987 Day StockstradedoverITS USA 1'
NSTS(CSE) 1985 Day 425stocks(2,700capability) USA 1',4,5
MAX(MSE) 1981 Day Exchangelistedstocks USA 1',2
ABS(NYSE) 1976 Day Bonds USA 5
OHT(NYSE) 1991 Night NYSEstocks USA 1
SCOREX(PSE) 1969 Day Listedstocks USA I'
PACE(PHLX) 1976 Day Listedstocks USA 1
SOES(NASD) 1985 Day NASDAQstocks USA 1
CORES(TSE) 1982 Day 1,612TSEstocks Japan 5
STS(OSE) 1991 Day 1,099OSEstocks Japan 5
CLOB(SSE) 1987 Day SSE,HKlistedstocks Singapore 5
CATS(TSE) 1977 Day 850TSEstocks Canada 5
HKTS(SEHK) 1993 Day SEHKlistedstocks HongKong 5
ELECTRA(CSE) 1987 Day 2,000bonds,275stocks Denmark 5
MATCHMAKER(VSE) 1988 Day 1,500stocks Canada 5
MAX-OTC(MSE) 1987 Day OTCstocks USA l'
SAX(SSM) 1989 Day Listedstocks,bonds Sweden 5
OLS(NYSE) 1986 Day OddlotsforNYSElistedstocks USA 1
'Spanishstockexchanges:Madrid,Barcelona,Bilbao,Valencia.
Alternative means ofautomating price discovery raise questions about market effi
ciency, the degree of regulatory oversight required, and the nature of trade abuses
possiblewithin theautomatedmarket. Forexample,Glosten(1991)showsthatanauto
mated continuous auction, operating under price and time priority rules with an elec
tronic order book, dominates a traditional specialist market in the sense of revenue
comparisons. The electronicexchange providesas much liquidityas possibleandelimi
natestheincentiveforinvestorstobreakuptradesintosequencesofsmallertransactions.
The analysis in Domowitz and Wang (1992) suggests that automated periodic markets
thatcompletelyendogenizethepricediscoveryprocessmayexhibitlowerpricevolatility
and smaller spreads than an automated continuous market with an electronic book.
Withinaparticularclassofcontinuousautomatedmarkets, Domowitz(1992b) indicates
7
308 IANDOMOWITZ
thattradeoffsinmarketefficiencymeasuresexistbetweensystemslimitedtoordersatthe
best price only and those that use electronicbooksthat represent bids and offers at all
possibleprices.Evenautomatedtradematchingsystems,whichlackanautomatedprice
discoverymechanism,affecttraderwelfareand market liquidity.4
Sevenlevelsofautomationofthepricediscoveryprocessarediscussedinsection1ofthis
article.Theclassificationsarenotbasedonsomenotionofan idealizedautomatedmarket
structure;rathertheyarebasedonthecharacteristicsofsystemsalreadyinexistenceorsoon
tobeoperational.Thelevelsare designed tobemutuallyexclusive. Asaconsequence, an
automatedmarketstructuremayembodyacombinationoftheselevelsofautomation.
Insection2,world tradingsystemsareanalyzedand classified intothesevenlevelsof
automation of price discovery. The diversity ofsystem design with respect to levels of
automationleadstoanexaminationofsystemswithrespecttoage,geographicallocation,
andtypeofinstrumentstraded.Someconvergenceofdesign overtime isidentified,and
remainingdifferencesare linked toinstrumenttype and location.
Thedegreeofautomationofprice discovery is then related to two types ofinforma
tional differences between systems. The first concerns information available to system
traders,suchastheavailabilityoforderbookdataandtheidentityoftraders.Thesecond
concernsasymmetriesin information provided toparticipantswith directsystem access
and thatprovidedtooutsideinvestors.Thedegreeofasymmetricinformationgenerally
growsasthelevelofautomationofpricediscoveryincreases,althoughautomatedsystems
havethecapabilityofequalizinginformationflow toall participants.
The proposition that the level of automation of price discovery is a key factor in
determiningthepotentialfortradingabusesistakenupinsection3.Regulatorypractices
varywidelyaroundtheworld,anditisnotpossibletoprovideaninternationalcomparison
ofsystem regulation in the samewayas the price discoverycomparisons. On the other
hand, issues of prearranged trading, noncompetitive execution of trades, and trading
aheadofcustomerswhodonothavedirectaccesstotheautomatedmarketarecommon
acrossmanyjurisdictions.Eachofthesethreeproblemsisexaminedbyrelatingthe level
ofautomationtothepotentialforabuse. Itisfound thatthespiritofregulatorylawscan
beviolatedintheseareas,despiteadherencetospecificlanguagewithrespecttoexposure
oforders to the market. Possibilities for abuse may be wider in some dimensions than
under conventional pit trading. Particularly important is the fact that regulation ofthe
form of the trade execution algorithm may not be desirable in order to rule out non
competitive trading, depending on the degree of automation of price discovery. The
overall implication is that the level ofsystem automation can affect the way in which
regulatoryauthoritiescarryouttheirobligations.
1. Levels ofautomation ofprice discovery
Thepotentialforefficientlydischargingthefundamental taskofpricediscoveryinfinan
cialmarketsbycomputerizedsystemshasbeenformallyrecognizedforalmost30years,5
but there is considerable diversity in how this task is carried out. The purpose ofthis
8