nep-mst New Economics Papers
on Market Microstructure
Issue of 2023‒07‒24
seven papers chosen by
Thanos Verousis

  1. High-frequency trading in the stock market and the costs of option market making By Nimalendran, Mahendrarajah; Rzayev, Khaladdin; Sagade, Satchit
  2. Price formation in markets with trading delays By Pinter, Gabor; Uslu, Semih
  3. An anatomy of the 2022 gilt market crisis By Pinter, Gabor
  4. The potential impact of broader central clearing on dealer balance sheet capacity: a case study of UK gilt and gilt repo markets By Baranova, Yuliya; Holbrook, Eleanor; MacDonald, David; Rawstorne, William; Vause, Nicholas; Waddington, Georgia
  5. A multi-agent targeted trading equilibrium with transaction costs By Jin Hyuk Choi; Jetlir Duraj; Kim Weston
  6. Bloated Disclosures: Can ChatGPT Help Investors Process Financial Information? By Alex Kim; Maximilian Muhn; Valeri Nikolaev
  7. Information, Insider Trading, Executive Reload Stock Options, Incentives, and Regulation By David B Colwell; David Feldman; Wei Hu; Monique Pontier

  1. By: Nimalendran, Mahendrarajah; Rzayev, Khaladdin; Sagade, Satchit
    Abstract: Using a comprehensive panel of 2, 969, 829 stock-day data provided by the Securities and Exchange Commission (MIDAS), we find that HFT activity in the stock market increases market-making costs in the options markets. We consider two potential channels - the hedging channel and the arbitrage channel - and find that HFTs' liquidity-demanding orders increase the hedging costs due to a higher stock bid-ask spread and a higher price impact for larger hedging demand. The arbitrage channel subjects the options market-maker to the risk of trading at stale prices. We show that the hedging (arbitrage) channel is dominant for ATM (ITM) options. Given the significant growth in options trading, we believe that our study highlights the need to better understand the costs/risks due to HFT activities in equity markets on derivative markets.
    Keywords: market microstructure; high-frequency trading; options market-making; hedging; liquidity
    JEL: G10 G00
    Date: 2022–01–17
  2. By: Pinter, Gabor (Bank of England); Uslu, Semih (Johns Hopkins Carey)
    Abstract: We develop a parsimonious price formation model to study information aggregation and information acquisition in the presence of trading delays. If delays apply uniformly to uninformed and informed traders, the level of delays does not affect information aggregation. Traders’ information acquisition incentives are, however, weaker in a market with longer delays. Therefore, the equilibrium fraction of informed traders is lower if delays are longer, establishing an inverse relationship between trading delays and price informativeness. We also show that risk premia and price dispersion tend to be non-monotonic functions of the level of delays when information acquisition is endogenous. We document novel empirical evidence from the UK corporate bond market, which largely corroborates the implications of our theory.
    Keywords: Trading frictions; trading delays; price informativeness; information aggregation; information acquisition; liquidity
    JEL: D49 D53 D82 D83 G11 G12 G14
    Date: 2023–06–22
  3. By: Pinter, Gabor (Bank of England)
    Abstract: We use transaction-level data on the UK government bond, repo and interest-rate swap markets to analyse market liquidity, investor behaviour and price dynamics during the market disruptions in September and October 2022. We provide a detailed account of how selling pressure in gilt markets – due to deteriorating derivative and repo positions of liability-driven investors (LDI) – led to evaporating market liquidity, especially in long-dated conventional gilts and index-linked gilts. We find that firms in the LDI-pension-insurance (LDI-PI) sector who had larger repo and swap exposure before the crisis sold more gilts during the crisis (while hedge funds were compensated for providing liquidity to the LDI-PI sector). Transaction costs in bond markets quickly soared, particularly for smaller trades, for trades at smaller dealers and for trades of non-LDI-PI investors too. The aggregate dispersion of transaction prices more than doubled in a matter of days, and price dispersion across primary dealers remained significant throughout the crisis, suggestive of tightened constraints on the intermediary sector. While the episode started with the forced selling by the LDI-PI sector, our results point to large costs on other market segments as well, consistent with the contagious nature of illiquidity.
    Keywords: Liquidity crisis; liability-driven investrors; gilt; repo; swap markets
    JEL: D83 D84 G11 G12 G14
    Date: 2023–03–31
  4. By: Baranova, Yuliya (Bank of England); Holbrook, Eleanor (Bank of England); MacDonald, David (Bank of England); Rawstorne, William (Bank of England); Vause, Nicholas (Bank of England); Waddington, Georgia (Bank of England)
    Abstract: More widespread central clearing could enhance dealers’ ability to intermediate financial markets by increasing the netting of buy and sell trades, thereby reducing the impact of trading on balance sheets and capital ratios. Drawing on trade‑level regulatory data, we study the netting benefits for UK dealers if comprehensive central clearing had been introduced to the cash gilt and gilt repo markets ahead of the March 2020 dash for cash (DFC) crisis. For the gilt repo market, we estimate that the policy would have reduced the gilt repo exposures on UK dealers’ balance sheets by 40% and, hence, boosted their aggregate leverage ratio by 3 basis points. If that policy had been accompanied by standardisation of repo maturity dates, such that they fell on the same day of the week (apart from for overnight repo), the reduction in exposures would have risen to 60% and the increase in the aggregate leverage ratio to 5 basis points. Such improvements in netting rates would in principle have allowed the dealers’ repo desks to expand their trading during the DFC by 2.5 times more than under prevailing clearing rates for each incremental unit of capital available to them. For cash gilt trades, central clearing would only have reduced unsettled trade exposures for dealers using a particular accounting treatment, but would have done so by up to 80% for that group, boosting its aggregate leverage ratio by 0.4 basis points. However, changes to the computation of the Basel III leverage ratio implemented in January 2023 would also have had these effects on cash trades.
    Keywords: Central clearing; dealers; gilts; market structure; repo
    JEL: G12 G18 G23 G28
    Date: 2023–06–02
  5. By: Jin Hyuk Choi; Jetlir Duraj; Kim Weston
    Abstract: We prove the existence of a continuous-time Radner equilibrium with multiple agents and transaction costs. The agents are incentivized to trade towards a targeted number of shares throughout the trading period and seek to maximize their expected wealth minus a penalty for deviating from their targets. Their wealth is further reduced by transaction costs that are proportional to the number of stock shares traded. The agents' targeted number of shares is publicly known, making the resulting equilibrium fully revealing. In equilibrium, each agent optimally chooses to trade for an initial time interval before stopping trade. Our equilibrium construction and analysis involves identifying the order in which the agents stop trade. The transaction cost level impacts the equilibrium stock price drift. We analyze the equilibrium outcomes and provide numerical examples.
    Date: 2023–06
  6. By: Alex Kim; Maximilian Muhn; Valeri Nikolaev
    Abstract: Generative AI tools such as ChatGPT can fundamentally change the way investors process information. We probe the economic usefulness of these tools in summarizing complex corporate disclosures using the stock market as a laboratory. The unconstrained summaries are dramatically shorter, often by more than 70% compared to the originals, whereas their information content is amplified. When a document has a positive (negative) sentiment, its summary becomes more positive (negative). More importantly, the summaries are more effective at explaining stock market reactions to the disclosed information. Motivated by these findings, we propose a measure of information "bloat." We show that bloated disclosure is associated with adverse capital markets consequences, such as lower price efficiency and higher information asymmetry. Finally, we show that the model is effective at constructing targeted summaries that identify firms' (non-)financial performance and risks. Collectively, our results indicate that generative language modeling adds considerable value for investors with information processing constraints.
    Date: 2023–06
  7. By: David B Colwell (UNSW Business School - UNSW - University of New South Wales [Sydney]); David Feldman (UNSW Business School - UNSW - University of New South Wales [Sydney]); Wei Hu (Curtin University [Perth] - PATREC - Planning and Transport Research Centre); Monique Pontier (IMT - Institut de Mathématiques de Toulouse UMR5219 - UT Capitole - Université Toulouse Capitole - UT - Université de Toulouse - INSA Toulouse - Institut National des Sciences Appliquées - Toulouse - INSA - Institut National des Sciences Appliquées - UT - Université de Toulouse - UT2J - Université Toulouse - Jean Jaurès - UT - Université de Toulouse - UT3 - Université Toulouse III - Paul Sabatier - UT - Université de Toulouse - CNRS - Centre National de la Recherche Scientifique)
    Abstract: We introduce a theoretical model of executives with insider information (insider-executives) granted incentivizing executive stock options (ESO). We show that while insider-executives optimize their wealth, using their insider information nullies ESO incentives, misaligning their and shareholders' interests. We oer realigning methods: granting insider-executives reload stock options (RSO) and imposing blackout trading periods (blackouts). Eective blackouts keep insider-executives incentivized without being overly restrictive, i.e., without reducing their welfare below that of outsiders. We introduce RSO pricing for insider-executives and oer policy implications: reestablishing the currently out-of-favor RSO, and allowing rms, not regulators, to set blackout periods on securities they issue.
    Keywords: Executive Stock Options, Insider Information, Constrained Portfolio Optimization, Non-Hedgeable, Non-Transferable, Reload, Enlarged Filtration
    Date: 2023–06–05

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