The Economic Function of a Stock Exchange PDF
Preview The Economic Function of a Stock Exchange
Zicklin School of Business Financial Markets Series Robert A. Schwartz John Aidan Byrne Lauren Wheatley Editors The Economic Function of a Stock Exchange The Economic Function of a Stock Exchange Zicklin School of Business Financial Markets Series Robert A. Schwartz, Editor ZicklinSchoolofBusiness BaruchCollege/CUNY NewYork,NY,USA Forothertitlespublishedinthisseries,goto www.springer.com/series/7133 (cid:129) Robert A. Schwartz John Aidan Byrne Lauren Wheatley Editors The Economic Function of a Stock Exchange Editors RobertA.Schwartz JohnAidanByrne ZicklinSchoolofBusiness NewYork,NY BaruchCollege/CUNY USA NewYork,NY USA LaurenWheatley ZicklinSchoolofBusiness BaruchCollege/CUNY NewYork,NY USA ISBN978-3-319-10349-5 e-ISBN978-3-319-10350-1 DOI10.1007/978-3-319-10350-1 SpringerChamHeidelbergNewYorkDordrechtLondon LibraryofCongressControlNumber:2014954251 ©SpringerInternationalPublishingSwitzerland2015 Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpart of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation,broadcasting,reproductiononmicrofilmsorinanyotherphysicalway,andtransmissionor informationstorageandretrieval,electronicadaptation,computersoftware,orbysimilarordissimilar methodologynowknownorhereafterdeveloped.Exemptedfromthislegalreservationarebriefexcerpts inconnectionwithreviewsorscholarlyanalysisormaterialsuppliedspecificallyforthepurposeofbeing enteredandexecutedonacomputersystem,forexclusiveusebythepurchaserofthework.Duplicationof this publication or parts thereof is permitted only under the provisions of the Copyright Law of the Publisher'slocation,initscurrentversion,andpermissionforusemustalwaysbeobtainedfromSpringer. PermissionsforusemaybeobtainedthroughRightsLinkattheCopyrightClearanceCenter.Violationsare liabletoprosecutionundertherespectiveCopyrightLaw. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt fromtherelevantprotectivelawsandregulationsandthereforefreeforgeneraluse. While the advice and information in this book are believed to be true and accurate at the date of publication,neithertheauthorsnortheeditorsnorthepublishercanacceptanylegalresponsibilityfor anyerrorsoromissionsthatmaybemade.Thepublishermakesnowarranty,expressorimplied,with respecttothematerialcontainedherein. Printedonacid-freepaper SpringerispartofSpringerScience+BusinessMedia(www.springer.com) Price Discovery: The Economic Function of a Stock Exchange1 We all know a stock exchange when we see it. The challenge is offering a clear and concise definition of a stock exchange. According to Webster’s Dictionary, a stock exchange is a place where security trading is conducted onanorganizedsystem.Armedwiththisinformation(andnothavingaclue what Webster was telling us!), we googled “organized system.” We came uponacoupleofentriesdealingwithhealthandthelike,atthetopwas“book binding.”Sothat’sit—astockexchangeisaplacewherewebindthebooks. It sure beats cooking them! AfurthersearchwithGoogleproducedasizableamountofdescriptionon astockexchange,specificallywiththisinsight:anexchangeisanassociation of stock brokers who meet and transact business according to recognized formsandregulations.Wecancertainlydobetterthanthiswasourimmedi- ate thought. Abetterapproachtodefininganexchange,weconcluded,wastofocuson the economic service that the institution provides. And that brings us to the titleofthispaper:Whatistheeconomicfunctionofastockexchange?Being Baruch professors, we offer the following multiple choice question: The economic function of a stock exchange is to: 1. Handle transactions with reasonable speed at reasonable cost (this one obviously has to be correct). 2. Find the two sides of a trade (well, quantity discovery does matter). 3. Produce the price (price discovery certainly is important). 1This chapter is a slightly amended paper of the same title by Nasli Sila Alan and Robert A.Schwartz,publishedintheJournalofPortfolioManagement,Fall2013.Thepaperwas developed from Schwartz’s Opening Comments at this 2011 Baruch conference in NewYorkCity.ReprintedwithpermissionfromtheJournalofPortfolioManagement. v vi The Economic Function of a Stock Exchange 4. Facilitatecapitalraisingintheprimarymarket(itisuncontestablethata vibrantIPOmarketisvitallycriticalforacountry’seconomicgrowth). 5. All of the above (this one drives our students crazy). The answer? Number 5, of course, “All of the above.” Of course, this is not the kind of pithy definition we were searching for. Afterabitmoreheadscratching,wedecidedtodrilldownonjustoneofthe answers—Number3,“Producetheprice.”Andbingo,wehadourdefinition: an exchange is the venue where share prices for listed securities are discov- ered. In this paper, we delve into some of the economic thinking that underlies this definition. PRICE DISCOVERY IS A PUBLIC GOOD We start by considering the economic importance of an exchange pro- duced price. Given the multiple uses to which a discovered price is put, efficient price discovery is critically important, not just to those who partic- ipate in a trade but to a far more extensive set of people. An exchange produced price is used for: (cid:129) Marking-to-market (cid:129) Derivative pricing (cid:129) Valuations of mutual fund cash flow (cid:129) Estate valuations (cid:129) Dark pool pricing Because the beneficiaries include a wide range of people who are not participating in the transactions that establish a price, an economist would refertoanexchangeproducedpriceasapublicgood.Aclassicexampleofa public good is the lighthouse in a harbor. Any ship passing in the night can see the lighthouse. Who among us would suggest that the light in the lighthouse be selectively shut off? You simply do not tell a ship’s captain, “No, youarenotallowedtoseethelight becauseyoudidnotpayto seeit.” The lighthouse is standing there on a rock, and all passing ships are con- sumers of the service that it provides but does not directly charge for. The lighthouse is a public good. We like the lighthouse image because an exchange-discovered price shines light on the value of shares for the broad public.2 The idea is the same—a broad spectrum of market participants looking at an exchange 2For earlier mention of the lighthouse image in the context of price discovery, see Robert A. Schwartz, “Dark Pools and Fragmented Markets,” World Federation of Exchanges, 2009AnnualReportandStatistics. Price Discovery: The Economic Function of a Stock Exchange vii produced price, and a ship’s captain spotting a lighthouse, all gain valuable information without directly paying for it.3 It is extremely important to remember this. So why hasn’t price discovery received more attention given its critical role as a public good? Of course, there is some analysis in theacademicliteratureandabitofhandwavingonthetopicaswell,andthe term “price discovery” does come up at times in regulatory discussions and documents.Nevertheless,theconceptofanexchange-producedpricebeinga public good receives woefully inadequate attention in public debates about market structure. THE COMPLEXITY OF PRICE DISCOVERY How difficult is price discovery, one might enquire? For a simple reason, price discovery is complicated and should not be taken for granted. We all talk about fundamental values, and about prices at times decoupling from fundamentalvalues,butstocksdonothavefundamentalvalues.Howcanwe say this? We will answer this question with a question: Do people agree in their stockanalyses?Consider this:About 2:00pmonApril 4, 2013,Apple shares traded at $429.38. Did all investors at that time believe that Apple shares were worth $429.38 exactly? Before we answer let us first explain. Clearly,if weall agree abouttheinputs of amodel,we willall get thesame answersandtherebyreachthesameconclusions.Butdoweagreeaboutthe inputs? Do we all even use the same models? What happens if we do not? The academic term that characterizes total agreement is “homogeneous expectations.” If investors do not have homogeneous expectations, the term usedis“divergentexpectations.”So,whichisit,homogeneousexpectations or divergent expectations? We think the latter (note that any disagreement about this would only serve to support our point). Of course, homogeneous expectations is a useful assumption for much modeling (e.g., the Capital Asset Pricing Model). Moreover, some academicians believe that the assumption is not unrealistic (identically informed and rational players, the argument goes, should all reach the same conclusions). But evidence is widespread that expectations are divergent. We hear substantial debate and disagreementamonginvestors,commentators,andstockanalystsaboutshare values.Weattributethistotheenormoussize,complexity,inexactitude,and incompleteness of the information set. Accordingly, the divergent 3Stockpricedataare,ofcourse,soldbyexchangesandboughtbycustomerswhowantinstant delivery,alongwithacademicianswhousetradeandquotedataforacademicresearch. viii The Economic Function of a Stock Exchange expectationsenvironmentistheonethatwewishtooperatewithinandbetter understand (see Davis et al. (2007) for further discussion). Now, if people disagree about a stock’s share value, wherein lies its fundamental value? Answer: nowhere. In a divergent expectations world, the market is there to find, not fundamental values, but equilibrium prices. Thatis,priceswhichharmonizethedesiresofacontinuumofdisparatebulls andbearstoholdshares.Findingthesepricesiswhatastockexchangedoes, and fulfilling this function is not a simple matter. MARKET STRUCTURE MATTERS Recognizingthatthequalityofpricediscoveryisimportant,onemightstill questionwhetherornotqualitydependsonthearchitectureofamarketplace. The answer is clear: the efficiency with which prices are discovered very much depends on the procedures, rules, and regulations that govern how orders are submitted, brought together, and turned into trades. For instance, the priority rules of order execution (price, time, size, etc.), the temporal consolidation of orders in call auction trading, the use of stock specific trading halts and across theboard circuit breakers, all determinehoworders interact. In so doing, all these establish trades and transaction prices. Three recent enactments by the Securities and Exchange Commission, along with remarkable technological developments, have intensified inter-market com- petition.TheseenactmentsweretheOrderHandlingRulesof1997;Regula- tion Alternative Trading Systems of 1998, and Regulation NMS (which includes the trade-through rule) fully implemented by 2007. This combina- tionofregulationsandtechnologyhasfragmentedthemarketplace,primarily for NYSE issues. The order flow is integrated differently in a fragmented marketplaceand,thus,pricediscoverycanbeaffected.Inalatersection,we consider the effect that NASDAQ’s opening and closing calls (instituted in 2004) have had on price volatility at market openings and closings. Market structure change, whether caused by technology developments, regulation,and/or competitivepressures,canbeassessedin termsofmarket characteristicssuchastradingcosts(e.g.,commissions,spreads,andmarket impact costs), consolidation/fragmentation of the order flow, pre- and post- trade transparency, market robustness/fragility, fairness, and the quality of price discovery. The quality of price discovery relates to each of its pre- decessorsonthelist:trading atdisequilibriumpricesis atrading cost; noisy price discovery obfuscates market transparency; price discovery is more apt to spin out of control in a fragile marketplace; and poorly discovered prices arefairneithertotraderswhoareactiveinthemarketnortothebroadmarket Price Discovery: The Economic Function of a Stock Exchange ix that uses exchange prices for a spectrum of non-trading purposes (As we have noted, an exchange produced price is a public good). We suggest that good quality price discovery be placed high on the regulatory priority list. With a sharper focus on price discovery, the other market characteristics should more readily fall into place. However, being high on the list comes with a necessary precondition that the objective be operational, which leads to a very key question: How can we assess the quality of price discovery? What can be used as a benchmark? INFERRING THE QUALITY OF PRICE DISCOVERY OnlyGodknowswhattheequilibriumpricemaybe,meremortalscannot see it. Unfortunately, because we are not able to quantify the deviations of actualpricesfromunobservableequilibriumvalues,thereisatendencynotto study market quality in terms of the efficiency of price discovery. Unobservability is indeed a debilitating reality from both an academic and a regulatory perspective. But all is not lost! We can assess the accuracy of price discovery by focusing on very short-period, intraday price volatility. Theefficiencyofpricediscoverycanbeinferredfromthelevelofintraday price volatility. That’s because intraday volatility is accentuated by micro- structure factors, most notably bid-ask spreads, market impact, and price discovery noise. Critically, the accentuation is too large to be explained entirely by spreads and market impact, especially in the neighborhood of market openings and closings. The dominant factor, in our opinion, is price discovery noise, particularly at market openings. This is at a time when, following the advent of overnight news, finding “the price” is most chal- lenged on a daily basis. ItiswellestablishedthatintradayvolatilityfollowsaU-shapedpattern.In fact, the U-shape is so severe that, in the opening and closing minutes, volatility shoots up sharply and the intraday pattern is more stapled-shaped thanU-shaped.Asnoted,weattributetheopeningspiketothecomplexityof price discovery (while the closing spike is largely a consequence of traders trying to “get the job done” before the market closes). Westresstheimportanceofanalyzingintradayvolatilityanditsimplications forpricediscoverywhenamarketisunderstress.Foritisatatimesuchasthis thatthecomplexitiesofpricediscoveryarebroughttolight.Inrelativelycalm periods, price discovery is not as big an issue, and the quality of a trading systemisnotparticularlychallenged.Wehoneinonstressbyfocusingonthe first half hour of trading and, in the section after the next that follows, by showing the price record for a stock (Disney) that, on a specific day (August 10,2011),exhibitedextraordinarilyhighfirsthalf-hourvolatility.
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