TOPIC 3
MARKET STRUCTURE AND
TRADING
B. Market Structure
More Structure is Needed!
2
Market Execution Structures
 Who provide liquidity
 Dealers
 The market (without dealer)
 Is trading continuous or not (in most exchanges)
 Call markets
Can only trade at certain times
All orders are executed at a single point in time
(clearing price) to maximizes liquidity
 Continuous markets
Trades are executed throughout the day
Provided there is enough liquidity in order book
3
Market Execution Structures
 Securities markets are categorized by their
execution systems, that is, their procedures for
matching buyers to sellers.
 Quote-driven markets where dealers post
quotes and participate on at least one side of
every trade (most OTC and bond markets)
 Order-driven markets where traders can trade
without the intermediation of dealers (most
exchanges)
 Brokered markets where many blocks are
broker-negotiated
 Hybrid markets have mixed characteristics of
more than one of the above 4
Quote Driven Market
 Dealers participate in very trade.
 Anyone who wants to trade must trade with a dealer
or market maker.
 Dealer’s ask is always higher than the bid and they
profit from the spread
 The dealers frequently trade among themselves
 Example: if Frank wants to buy a security, he must
find a dealer who will sell it to him from his
inventory. Similarly, if Gordon wants to sell a
security, he must find a dealer who is willing to buy
from him
 Although Frank might be willing to buy the security
directly from Gordon, in a pure quote-driven market
they generally cannot arrange such trades. 5
Order Driven Market
 Participants meet to establish prices and regularly trade
with each other.
 Some are looking to buy
 Some are looking to sell
 Some post limit orders
 Some submit market orders
 Most order-driven markets are auction markets. In an
auction market, prescribed trading rules formalize the
process by which they arrange their trades, the order
precedence rules and trade pricing rules or price discovery
process
 The market is therefore driven by the orders placed on the
order book. There are many different types of orders.
depending on the particular need of the trader at that
moment of time
 Limit orders drive an order driven market. Without
sufficient limit orders, the order driven market would fail!
 Orders in the limit book (LOB) determine the supply
and demand schedules
6
What Motivates and Discourages the
Placement of Limit Orders
 Information change (new information arrives, news
event occurs) affects placement of limit order.
 Head you win, Tail I lose
 This is the cost of trading by limit order
 Non-execution cost when there is no information change
 Mean reversion compensates the limit order trader
 A liquidity event that results in a price decline could cause
my buy limit order to execute
 After being driven down, price would revert back up
 I profit as price mean reverts after my order has executed
 Sufficient mean reversion can offset the costs that result
from informational change
7
Intra-Day Volatility
 Increased intra-day volatility implies negative
serial correlation
 Negative serial correlation implies mean
reversion
 Intra-day volatility is heightened due to
 Liquidity events
 Technical trading
 Heightened volatility is a natural property of the
continuous market
8
Order Placement in an Order Driven Market
 Should I:
 Submit a market order?
 A limit order?
 If a limit order, how should I price it?
 The decision is made with respect to:
 Gains from trading
 Probability of a limit order executing
9
Order Driven Market Can Break Down
 Stressful conditions
 A bear market
 Advent of news
 Derivatives expirations
 Momentum trading
 Daily openings
 Arrival of a very large order
 Liquidity becomes a problem
10
Order Driven Market Structures
 vary considerably:
 Some markets conduct single-price auction in
which they arrange all trades at the same price
following a market call.
 Other markets conduct continuous two-sided
auctions, in which buyers and sellers can
continuously attempt to arrange their trades at
prices that typically vary through time.
11
Brokered Market
 Brokers actively search to match buyers and
sellers when their clients ask them to fill orders
 The role of broker is important in finding
liquidity
 In markets where traders usually do not make
public orders to trade, brokers must search for
traders who will make those orders. These
markets are typically illiquid markets in which
dealers will not normally trade and will not
normally hold inventory
12
Hybrid Market
 Combination of the characteristics of quote-
driven, order-driven, and brokered markets.
 The New York Stock Exchange is essentially an
order-driven market, but it requires its specialist
dealers to order liquidity if no one else will do so.
 The Nasdaq Stock Market is essentially a quote-
driven market, but its dealers are also required
to execute public limit orders
 The Hong Kong Stock Exchange is essentially
order driven but it employs the call auction
market
13
Quote-Driven Market - Dealer or Market
Maker Services
 Immediacy
 facilitate the rapid execution of customer orders
 Do not like to hold positions
 Supplemental liquidity by quoting bid and ask
prices
 They buy when their customers want to sell and sell
when customers want to buy
 Better prices or quotes for larger sizes may be
obtained through negotiation
 Price discovery
 Price improvement
14
Market Maker Revenue & Costs
 Revenue from:
 Bid-ask spread of a round trip transaction
 Risk aversion
 Inventory control
 Information asymmetry
 Trading the Order Flow and turn their inventory
quickly
 Speculating
 Costs of:
 Inventory: Cost of carrying unbalanced inventory
 Information: Cost of trading with better informed
participants
15
For a Successful Market Maker
 Inventory control
 If prices are too low, there will be too many buyers
and dealer inventories will fall
 If prices are too high, there will be too many sellers
and dealer inventories will rise.
 Quote to reduce a long or short inventory position (to
skew the probabilities in his favour)
 Trading the order flow carefully not to move the
market
 Ability to hide/disguise large positions
 Knowledge of customers (source of the order flow
of informed traders) is also important in practice 16
Shading the Market Price
 Suppose the market for a stock is
 If you were a buyer of the stock, you would quote
 With a small margin
 Similarly, if you were a seller, you move your ask
down or to the left.
17
BID ASK
60.50 61.50
BID Your Bid ASK
60.50 60.75 61.50
Price Dynamics
 The market maker adjusts his bid-ask up or
down in response to movement of the market
price.
 Raise the bid and ask – we want to buy as market is
rising
 Lower the bid and ask – we want to sell as market is
falling
 Change the bid and ask quantities
 Information content of prices
18
Price information
 Demand and supply
 Fundamentals
 Order flow
 Market psychology – technical analysis
 Macro economics
19
Buy side orders
 Unless you are keeping the risk position, you (the
market maker), are on the same side of the
market as the client.
 If the client is a buyer, then depending on the
type of order, you could post a bid, or lift the
nearest offer(s).
 If the client is a seller, then you could post an
ask, or hit the nearest bid(s).
20
Marking to Market
 In any trading sessions, your trading book will be
marked to market.
 That is the assigning of a value to a position held
in a financial instrument based on the current
fair market price for the instrument
 it is the value of your open position, and hence
the profit or loss on it at that moment
 When your position is closed then this becomes
trading profit or loss
21
TOPIC 3
MARKET STRUCTURE AND
TRADING
C. Role of Exchanges
Exchanges and Floor Markets
 An exchange is an organized and centralized
place to facilitate the buying and selling. A floor
market has a physical room, pit or other location
where buyers and sellers meet.
 Nowadays, buyers and sellers meet virtually on a
computer screen-based system provided by
Electronic Communications Networks (ECNs).
 Exchange trading is widely used for stocks,
options and futures
23
Exchange Functions
 Exchanges are intended to provide an
intermediation for orderly, liquid and continuous
markets for the securities they trade.
 Exchanges primarily regulate their members'
trading practices. Their rules specify how their
members arrange trades and how they should
relate to their clients.
 In addition, exchanges traditionally serve as self-
regulatory organizations (SROs) for their
members, regulating and policing their behavior
with respect to a variety of rules and
requirements. 24
Early Exchanges
 Precursors to modern stock exchanges might have existed
in Egypt as early as the 11th century, where it is believed
that Jewish and Islamic brokers traded a variety of credit-
related instruments.
 The Amsterdam Stock Exchange opened in the early 17th
century, trading shares of the Dutch East India Company.
The exchange continues to operate as a unit of Euronext,
and as the world's longest continuously operated exchange.
 Several older exchanges began in coffee houses and
taverns, where brokers and dealers would meet to trade
securities.
 The New York Stock Exchange began operations outdoors
after the 1792 signing of the “Buttonwood Agreement.”
 Exchanges often operated outdoors so that brokers could
call out their orders from their office windows to the street
where transactions actually took place.
25
Direct Access Trading
 Enable traders to execute transactions directly
with market makers and designated market
makers. Direct market access (DMA) trading
systems may provide for faster and superior
execution for such traders by eliminating the
broker from transaction participation
 Direct access trading through firms such as such
as Interactive Brokers, and TD Ameritrade
enable traders to execute directly with market
makers and designated market makers on the
NYSE, Nasdaq and ECNs, eliminating brokers
from transactions. 26
27
Market Cap of Major World Exchanges
Rank Stock exchange Country
Market
place
Market cap
(USD bn)
Rank
in
Asia
1 New York Stock Exchange United States New York 24,680
2 NASDAQ United States New York 19,500
3 Shanghai Stock Exchange China Shanghai 7,050 1
4 Euronext
European
Union
Amsterdam
5,900
Brussels
Dublin
Lisbon
Paris
5 Japan Exchange Group Japan Tokyo 5,310 2
6 Shenzhen Stock Exchange China Shenzhen 5,150 3
7 Hong Kong Stock Exchange China Hong Kong 4,570 4
8 London Stock Exchange Group
United
Kingdom
London 3,170
Milan
9 National Stock Exchange India Mumbai 3,320 5
10 TMX Group Canada Toronto 2,970
*as on Jul 2022 (Source: Statista)
Hong Kong Stock Exchange (HKEX)
 https://www.youtube.com/watch?v=E9qQ-SwbGHI
 https://www.hkex.com.hk
28
The Trading Floor (Financial Institutions)
 Also called the trading room, dealing room or front
office
 A high-energy and dynamic place where trading is
done
 Lots of new sophisticated technologies are used
(telecommunication, computer, IT system)
 The classic open office environment with rows of long
desks or trading desks each specialized by market
segment or products
 Equity trading
 FX
 Bond, Fixed Income
 Derivatives, option, commodity
 FI sales 29
What Happen Inside?
 manage liquidity / cash of the bank
 buying and selling of products for clients or bank
occur
 sales and contact with clients
 factory of financial products
 Typical posts and roles:
 Sales
 Traders
 Structurers
 Research Analysts
 Fast reactions, good judgement, customer focused,
attention to details, excellent communication skills
 https://www.bbva.com/en/trading-floor/ 30
TOPIC 3
MARKET STRUCTURE AND
TRADING
D. Market Microstructure
Market Microstructure
 Uses a magnifying glass to look how trades are
occurring and why
 It is concerned with the transaction-to-
transaction behavior in the market and the
impact of transactions costs on the short run
behavior of securities prices
 Market microstructure concerns how the design
of the market affects the exchange of assets,
trading costs, price formation and price
discovery.
32
Introduction to Market Microstructure
 Market microstructure examines latency, the
amount of time that lapses from when a quote or
an order is placed by a trader and when that
quote or order execution is actually visible to the
market.
 Generally, the best market is that which has the
lowest transactions costs, facilitates the fastest
trades, results in the fairest prices, disseminates
price information most efficiently and provides
for the greatest liquidity.
 A market is said to be liquid when prospective
purchasers and sellers can transact on a timely
basis with little cost or adverse price impact. 33
Liquidity
 Liquidity refers to an asset's ability to be easily
purchased or sold without causing significant
change in the price of the asset.
 To trade in reasonable size, reasonable price,
reasonable amount of time
 There are lots of orders on the book and lots of
order flow
 always bid and ask prices for investors who want to
transact small amounts immediately.
 The difference between the bid and asked prices (the
spread) is small.
 Without sufficient liquidity, a market will not
function
34
Four Dimensions of Liquidity
 Immediacy: how quickly can we trade?
 Width (also known as tightness): the bid-offer
spread affect the cost of trading
 Depth: the market’s ability to process and execute
a large order without substantially impacting its
price. (Size or Quantity)
 Slippage (also known as market impact, price
impact or market resilience), which indicates the
speed with which the price pressure resulting
from a non-informative trade execution is
dissipated (price reverts to normal or former
level). 35
Depth
 Normally, markets with more active participants
(ready and willing buyers and sellers at all times)
have more depth than thin markets.
 Suppose, for example, that there are two competing
markets for Stock X with the following offer prices
(central limit order book) for Stock X as depicted:
36
Market A Market B
#shares Offer #shares Offer
1000 50.00 2000 50.00
2000 50.03 1000 50.01
1000 50.05 2000 50.03
2000 50.06 2000 50.04
3000 50.07 2000 50.05
1000 50.09 3000 50.05
Market Depth
 Suppose that the last transaction for Company X
stock was at a price of 50.00. Further suppose
that an investor places a market order to buy
5,000 shares of company X stock. In market A,
the investor will obtain 1000 shares for $50.00,
2000 for $50.03, 1000 for $50.05 and 1000 for
$50.06. The final price rises to $50.06. In market
B, the investor will obtain 2000 shares for $50.00,
1000 for $50.01 and 2000 for $50.03. The final
price in Market B rises to $50.03, less than
Market A.
 Market B’s depth exceeds that for Market A, at
least with respect to stated demand for this
stock.
37
Depth