New Economics Papers
on Market Microstructure
Issue of 2011‒05‒14
five papers chosen by
Thanos Verousis

  1. Dark Pool Trading Strategies By Sabrina Buti; Barbara Rindi; Ingrid M. Werner
  2. The Impact of Dark and Visible Fragmentation on Market Quality By Degryse, H.A.; Jong, F.C.J.M. de; Kervel, V.L. van
  3. Trading and Liquidity with Limited Cognition By Biais, Bruno; Hombert, Johan; Weill, Pierre-Olivier
  4. Optimal algorithmic trading and market microstructure By Mauricio Labadie; Charles-Albert Lehalle
  5. Large Deviations of Realized Volatility By Shin Kanaya; Taisuke Otsu

  1. By: Sabrina Buti; Barbara Rindi; Ingrid M. Werner
    Abstract: We model a dynamic financial market where traders submit orders either to a limit order book (LOB) or to a Dark Pool (DP). We show that there is a positive liquidity externality in the DP, that orders migrate from the LOB to the DP, but that overall trading volume increases when a DP is introduced. We also demonstrate that DP market share is higher when LOB depth is high, when LOB spread is narrow, when the tick size is large and when traders seek protection from price impact. Further, while inside quoted depth in the LOB always decreases when a DP is introduced, quoted spreads can narrow for liquid stocks and widen for illiquid ones. We also show that traders? interaction with both LOB and DP generates interesting systematic patterns in order ?ow: di¤erently from Parlour (1998), the probability of a continuation is greater than that of a reversal only for liquid stocks. In addition, when depth decreases on one side of LOB, liquidity is drained from DP. When a DP is added to a LOB, total welfare as well as institutional traders' welfare increase but only for liquid stocks; retail traders'welfare instead always decreases. Finally, when flash orders provide select traders with information about the state of the DP, we show that more orders migrate from the LOB to the DP, and DP welfare e¤ects are enhanced.
    Date: 2011
  2. By: Degryse, H.A.; Jong, F.C.J.M. de; Kervel, V.L. van (Tilburg University, Center for Economic Research)
    Abstract: Two important characteristics of current European equity markets are rooted in changes in financial regulation (the Markets in Financial Instruments Directive). The regulation (i) allows new trading venues to emerge, generating a fragmented market place and (ii) allows for a substantial fraction of trading to take place in the dark, outside publicly displayed order books. This paper evaluates the impact on liquidity of fragmentation in visible order books and dark trading for a sample of 52 Dutch stocks. We consider global liquidity by consolidating the entire limit order books of all visible European trading venues, and local liquidity by considering the traditional market only. We find that fragmentation in visible order books improves global liquidity, but dark trading has a detrimental e¤ect. In addition, local liquidity is lowered by fragmentation in visible order books.
    Keywords: Market microstructure;Market fragmentation;Liquidity;MiFID.
    JEL: G10 G14 G15
    Date: 2011
  3. By: Biais, Bruno (Toulouse School of Economics (CNRS-CRM, IDEI)); Hombert, Johan (HEC Paris); Weill, Pierre-Olivier (University of California and NBER)
    Abstract: We study the reaction of nancial markets to aggregate liquidity shocks when traders face cognition limits. While each nancial institution recovers from the shock at a random time, the trader representing the institution observes this recovery with a delay, reecting the time it takes to collect and process information about positions, counterparties and risk exposure. Cognition limits lengthen the recovery process. They also imply that traders who nd their institution has not yet recovered from the shock place market sell orders, and then progressively buy back at relatively low prices, while simultaneously placing limit orders to sell later when the price will have recovered. This generates round trip trades, which raise trading volume. We compare the case where algorithms enable traders to implement this strategy to that where traders can only place orders when they have completed their information processing task.
    Keywords: Liquidity shock, Limit-orders, Asset pricing and liquidity, Algorithmic trading, Limited cognition, Sticky plans
    JEL: D83 G12
    Date: 2010–12–07
  4. By: Mauricio Labadie (CAMS - Centre d'analyse et de mathématique sociale - CNRS : UMR8557 - Ecole des Hautes Etudes en Sciences Sociales (EHESS)); Charles-Albert Lehalle (Head of Quantitative Research - CALYON group)
    Abstract: The efficient frontier is a core concept in Modern Portfolio Theory. Based on this idea, we will construct optimal trading curves for different types of portfolios. These curves correspond to the algorithmic trading strategies that minimize the expected transaction costs, i.e. the joint effect of market impact and market risk. We will study five portfolio trading strategies. For the first three (single-asset, general multi-asseet and balanced portfolios) we will assume that the underlyings follow a Gaussian diffusion, whereas for the last two portfolios we will suppose that there exists a combination of assets such that the corresponding portfolio follows a mean-reverting dynamics. The optimal trading curves can be computed by solving an N-dimensional optimization problem, where N is the (pre-determined) number of trading times. We will solve the recursive algorithm using the "shooting method", a numerical technique for differential equations. This method has the advantage that its corresponding equation is always one-dimensional regardless of the number of trading times N. This novel approach could be appealing for high-frequency traders and electronic brokers.
    Keywords: quantitative finance; optimal trading; algorithmic trading; market microstructure
    Date: 2010–10–01
  5. By: Shin Kanaya (Dept. of Economics, Nuffield College and Oxford-Man Institute); Taisuke Otsu (Cowles Foundation, Yale University)
    Abstract: This paper studies large and moderate deviation properties of a realized volatility statistic of high frequency financial data. We establish a large deviation principle for the realized volatility when the number of high frequency observations in a fixed time interval increases to infinity. Our large deviation result can be used to evaluate tail probabilities of the realized volatility. We also derive a moderate deviation rate function for a standardized realized volatility statistic. The moderate deviation result is useful for assessing the validity of normal approximations based on the central limit theorem. In particular, it clarifies that there exists a trade-off between the accuracy of the normal approximations and the path regularity of an underlying volatility process. Our large and moderate deviation results complement the existing asymptotic theory on high frequency data. In addition, the paper contributes to the literature of large deviation theory in that the theory is extended to a high frequency data environment.
    Keywords: Realized volatility, Large deviation, Moderate deviation
    JEL: C10 C20
    Date: 2011–05

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