New Economics Papers
on Market Microstructure
Issue of 2014‒03‒30
four papers chosen by
Thanos Verousis

  1. Single stock circuit breakers on the London Stock Exchange: do they improve subsequent market quality? By James Brugler; Oliver Linton
  2. A Behavioural Model of Investor Sentiment in Limit Order Markets By Carl Chiarella; Xue-Zhong He; Lei Shi; Lijian Wei
  3. The simplicity of optimal trading in order book markets By Paolo Pellizzari; Dan Ladley
  4. Competing for order flow in OTC markets By Lester, Benjamin; Rocheteau, Guillaume; Weill, Pierre-Olivier

  1. By: James Brugler; Oliver Linton (Institute for Fiscal Studies and Cambridge University)
    Abstract: This paper uses proprietary data to evaluate the efficacy of single-stock circuit breakers on the London Stock Exchange during July and August 2011. We exploit exogenous variation in the length of the uncrossing periods that follow a trading suspension to estimate the effect of auction length on market quality, measured by volume of trades, frequency of trading and the change in realized variance of returns. We also estimate the effect of a trading suspension in one FTSE-100 stock on the volume of trades, trading frequency and the change in realized variance of returns for other FTSE-100 stocks. We find that auction length has a significant detrimental effect on market quality for the suspended security when returns are negative but no discernible effect when returns are positive. We also find that trading suspensions help to ameliorate the spread of market microstructure noise and price inefficiency across securities during falling markets but the reverse is true during rising markets. Although trading suspensions may not improve the trading process within a particular security, they do play an important role preventing the spread of poor market quality across securities in falling markets and therefore can be effective tools for promoting market-wide stability.
    Date: 2014–02
  2. By: Carl Chiarella (Finance Discipline Group, UTS Business School, University of Technology, Sydney); Xue-Zhong He (Finance Discipline Group, UTS Business School, University of Technology, Sydney); Lei Shi (Finance Discipline Group, UTS Business School, University of Technology, Sydney); Lijian Wei (Finance Discipline Group, UTS Business School, University of Technology, Sydney)
    Abstract: This paper examines the effect of behavioral sentiment in a limit order market when agents are risk averse and arrive in the market with different time horizons. The order submission rules with respect to order type and size are determined by maximizing the expected utility of agents with heterogeneous beliefs on the fundamental price and investment horizon. We show that behavioral sentiment has a double-edge impact on market quality: it improves market liquidity by reducing bid-ask spread and market volatility but increasing trading volume; however, it reduces pricing ef?ciency by increasing the price deviation from the fundamental value. Consistent with empirical observations, the model is able to replicate a number of stylized facts and limit book phenomena, including insigni?cant autocorrelations in returns, but signi?cant and decaying autocorrelations in the absolute returns, the bid-ask spread and the trading volume, hump shaped order books, a concave relationship between trade imbalance and average mid-price returns, and event clustering in order submissions. More important, the behavioral sentiment plays a very important role in explaining the positive autocorrelation in trading volume and also event clustering.
    Date: 2014–02–01
  3. By: Paolo Pellizzari (Department of Economics, University Of Venice Cà Foscari); Dan Ladley (Department of Economics Leicester University)
    Abstract: A trader's execution strategy has a large effect on his profits. Identifying an optimal strategy, however, is often frustrated by the complexity of market microstructure's. We analyse an order book based continuous double auction market under two different models of trader's behaviour. In the first case actions only depend on a linear combination of the best bid and ask. In the second model traders adopt the Markov perfect equilibrium strategies of the trading game. Both models are analytically intractable and so optimal strategies are identified by the use of numerical techniques. Using the Markov model we show that, beyond the best quotes, additional information has little effect on either the behaviour of traders or the dynamics of the market. The remarkable similarity of the results obtained by the linear model indicates that the optimal strategy may be reasonably approximated by a linear function. We conclude that whilst the order book market and strategy space of traders are potentially very large and complex, optimal strategies may be relatively simple and based on a minimal information set.
    Keywords: Continuous Double Auction, Order Book, Information, Optimal Trading
    JEL: D44 G10 C63
    Date: 2014
  4. By: Lester, Benjamin (Federal Reserve Bank of Philadelphia); Rocheteau, Guillaume (University of California–Irvine); Weill, Pierre-Olivier (University of California–Los Angeles)
    Abstract: The authors develop a model of a two-sided asset market in which trades are intermediated by dealers and are bilateral. Dealers compete to attract order flow by posting the terms at which they execute trades, which can include prices, quantities, and execution times, and investors direct their orders toward dealers that offer the most attractive terms of trade. Equilibrium outcomes have the following properties. First, investors face a trade-off between trading costs and speeds of execution. Second, the asset market is endogenously segmented in the sense that investors with different asset valuations and different asset holdings will trade at different speeds and different costs. For example, under a Leontief technology to match investors and dealers, per unit trading costs decrease with the size of the trade, in accordance with the evidence from the market for corporate bonds. Third, dealers’ implicit bargaining powers are endogenous and typically vary across sub-markets. Finally, the authors obtain a rich set of comparative statics both analytically, by studying a limiting economy where trading frictions are small, and numerically. For instance, the authors find that the relationship between trading costs and dealers’ bargaining power can be hump-shaped.
    Keywords: Over-the-counter markets; OTC Markets; Order Flow;
    Date: 2014–03–13

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