nep-mst New Economics Papers
on Market Microstructure
Issue of 2018‒02‒05
four papers chosen by
Thanos Verousis

  1. Execution in an aggregator By Oomen, Roel
  2. The Effect of Market Volatility on Liquidity and Stock Returns in the Korean Stock Market By Jieun Lee; KeeH.Chung
  3. Discriminatory Pricing of Over-The-Counter Derivatives By Hau, Harald; Hoffmann, Peter; Langfield, Sam; Timmer, Yannick
  4. The Effect of Implicit Market Barriers on Stock Trading and Liquidity By Asem Alhomaidi; M. Kabir Hassan; William J. Hippler

  1. By: Oomen, Roel
    Abstract: An aggregator is a technology that consolidates liquidity—in the form of bid and ask prices and amounts—from multiple sources into a single unified order book to facilitate ‘best-price’ execution. It is widely used by traders in financial markets, particularly those in the globally fragmented spot currency market. In this paper, I study the properties of execution in an aggregator where multiple liquidity providers (LPs) compete for a trader’s uninformed flow. There are two main contributions. Firstly, I formulate a model for the liquidity dynamics and contract formation process, and use this to characterize key trading metrics such as the observed inside spread in the aggregator, the reject rate due to the so-called ‘last-look’ trade acceptance process, the effective spread that the trader pays, as well as the market share and gross revenues of the LPs. An important observation here is that aggregation induces adverse selection where the LP that receives the trader’s deal request will suffer from the ‘Winner’s curse’, and this effect grows stronger when the trader increases the number of participants in the aggregator. To defend against this, the model allows LPs to adjust the nominal spread they charge or alter the trade acceptance criteria. This interplay is a key determinant of transaction costs. Secondly, I analyse the properties of different execution styles. I show that when the trader splits her order across multiple LPs, a single provider that has quick market access and for whom it is relatively expensive to internalize risk can effectively force all other providers to join her in externalizing the trader’s flow thereby maximizing the market impact and aggregate hedging costs. It is therefore not only the number, but also the type of LP and execution style adopted by the trader that determines transaction costs.
    Keywords: aggregation; liquidity access; transaction costs; adverse selection; prisoner's dilemma; market impact
    JEL: F3 G3
    Date: 2017–05–01
  2. By: Jieun Lee (Economic Research Institute, The Bank of Korea); KeeH.Chung (Department of Finance, School of Management, University at Buffalo, The State University of New York)
    Abstract: This study analyzes the effect of market volatility on stock returns using data from the Korean stock market from January 1, 2004 to December 31, 2014. We show that unexpected increases in market volatility accompany decreases in both stock returns and liquidity and the effect of volatility shock on stock returns is greater for stocks with more domestic or foreign institutional trading. Individual investors mitigate the negative effect of volatility shock on stock returns. The interaction effect of market volatility and liquidity on stock returns is stronger for stocks with more foreign institutional trading. We also document some evidence of asymmetric effects of market volatility on stock returns that are related to whether trades are buyer or seller-initiated.
    Keywords: Market volatility, VIX, Price impact, Bid-ask spread, Liquidity, Stock returns, Investor type, Financial crisis
    JEL: G10 G32 G34
    Date: 2017–06–20
  3. By: Hau, Harald; Hoffmann, Peter; Langfield, Sam; Timmer, Yannick
    Abstract: New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.
    Keywords: corporate hedging; Dealer spreads; information rents; RFQ platforms
    JEL: D4 G14 G18
    Date: 2017–12
  4. By: Asem Alhomaidi; M. Kabir Hassan; William J. Hippler
    Abstract: We compare the performance of Islamic and conventional stock returns in Saudi Arabia in order to determine whether the Saudi market exhibits characteristics that are consistent with segmented markets and investor recognition effects. We sample the daily stock returns of all Saudi firms from September 2002 to 2015 and calculate important measures, including idiosyncratic volatility (Ang et al, 2006), market integration (Pukthuanthong and Roll, 2009), systematic turnover (Loughran and Schultz, 2005), and stock turnover and liquidity (Amihud, 2002). Integration tests report that Islamic stocks are more sensitive to changes in global and local macroeconomic variables than conventional stocks, supporting the hypothesis that the Islamic and conventional stock markets are segmented in Saudi Arabia. In addition, our results show that Islamic stocks have a broader investor base, lower idiosyncratic risk, higher systematic turnover, and are more liquid than conventional stocks, which support the investor recognition hypothesis. Our results provide new evidence on asset pricing in emerging markets, the evolving Islamic financial markets, and the potential impact of other implicit market barriers on global financial markets.
    Keywords: Segmented markets, Islamic finance, Emerging markets, Asset pricing, Investor recognition
    JEL: G1 G2 F3 P5
    Date: 2018–01

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