Financial Markets Microstructure - Lecture 1

hello and welcome to financial markets microstructure this is a master's level university course that was read in the university of copenhagen in the spring of 2020 like many other courses especially university courses in that time period this one was affected by the outbreak of the covet 19 virus which led to most of the scores being read online in particular the 10 out of the 16 lectures and 3 out of 5 exercise classes were held as live streams and the recordings of these classes were uploaded to youtube and these are the recordings that you will get that you will get to see if you follow this if you decide to follow this course given that relatively few classes were missing i decided to re-record these classes separately not the exercise classes but the lectures at the very least and uh complement the existing recordings to a full course experience now i would like to warn you that these recordings will be one pass with no editing whatsoever not because i do not want to do better but because i would not want to create any false expectations about the quality of the second half of the course and not create a sudden quality shock all of the materials for this course can be found on my personal website and i by the way is igor starkov an assistant professor at the university of copenhagen so on my website let's start over the site in this section on teaching you can find the slides for the course as well as problem sets in the exams in these lectures i give exercises at the end of any given lecture and those quite often involve reading some of the articles not the academic articles quite often but rather magazine articles from journals such as the economist bloomberg and etc the course files on my website include the full reading list which gives you exact links to those articles as i mentioned the course files also include the problem sets larger more cumulative problem sets that you can do to exercise the knowledge you obtained in lectures and there is also the final exam for the course it is not available as of now at the point of view of the at the point of this recording but i will upload it sometime during the summer of 2020. this course is largely based on a single textbook and this is a textbook by terry foucault marco pagano and ilse hoyle and this is a great textbook on market microstructure this book was published in 2013 so it is relatively recent and for the two-thirds of the course we will mostly be following this textbook now it is completely understandable if you would rather read the textbook than listen to this not very interactive podcast uh so if you would rather skip anything that you can easily read in the textbook then i invite you to start at lecture 11 at the second half of lecture 11. where the course switches from the textbook to research articles and at that point the course becomes a little more creative it not simply retells the articles but it regurgitates to some extent those articles and present them in a more digestible form unlike again the first two thirds were i more or less just retell you the textbook so this was the logistics of this course and there was obviously not that much given that this is an online youtube recording so let us now get to the course itself and we will start by figuring out what is this course about exactly so this is a course on financial markets let us take a step back and figure out what are markets in general and why do we want to study them so the first question is what is a market webster dictionary defines no i guess not that but a market broadly speaking is a set institution in which property rights are exchanged between different economic agents similar way to saying that is a market is a place where people trade and the place can be defined relatively broadly so it can be a physical place like a market square in a town or it can be a digital platform or it can be a cumulative set of abstract um abstract concepts let's say for example if you think of any shady markets like drugs market weapons market there is no physical place or online platform for those but rather we mean those in their very ethnic ethereal senses so why do we want to study markets as i said the whole point of markets is that they enable the exchange of property rights between different agents and these exchanges happen in such a way as to well more often than not improve market welfare improve social welfare improve the total surplus in the society because the way it usually happens is the items change hands from the person who values it little to a person who values it more otherwise the trade is unreasonable at the very least this is the kind of trained trade that we would like to see so we would like property rights to be allocated efficiently in the society meaning that for any given item we would ideally want the person who values it the most to own this item and in order to achieve this allocation we need to ensure that markets function smoothly that the exchanges do occur and the exchanges happen in a efficient way that items change hands even only if this leads to an increase in social welfare if and only if it is traded from the person who values it little to the person who values it more so we would like to study markets to ensure how exactly we can ensure this efficiency now what is so special about the financial markets in particular let us again begin with asking what exactly are financial markets how do they differ from the standard market well financial markets are obviously just markets for financial assets these are markets in which a particular class of items is traded and financial assets are special in that you basically just buy money with money right if you think about any example of financial assets such as stocks bonds derivatives you pay the money now to own to own one of these assets which will the sole purpose of which asset is to yield you more money in the future so why to do that two reasons firstly you might want to reallocate your wealth over time in case you're buying some kind of riskless asset you are investing your money away in order to obtain more money later alternatively you might want to reallocate your wealth across different contingencies of the world simply speaking there are many different scenarios of the future there are many different possibilities which may or may not occur and your financial situation may be such that in some of these contingencies you obtain a lot and in some of these contingencies you obtain little for example if you are working in the coal industry you your well-being will be okay if the renewable energy does not pick up well if it does pick up then you will likely lose your job and your wealth in that contingency in that version of the future will be diminished so you may want to ensure against that and move your wealth across these two contingencies that i just mentioned and in this particular example an optimal investment for you would actually to would actually be to invest in some of the renewable energy companies because such investments would only pay off if renewable energy picks up and by investing some share of your existing wealth into those assets you would equalize your wealth you would ensure your future wealth across different possible scenarios of the world so these are financial assets they allow you to move wealth across time and contingencies and the important aspect of this specifics of the fact that financial assets move well the cross contingencies across different versions of the future is that different people may have different information about how likely these different contingencies are in particular if you are working in the coal industry you might have a better insight as to what is the current state's current state of the oil of the coal industry while if you're working in renewable energy you are more informed about what are the actual prospects of the renewable energy so these markets feature a lot of what we will call asymmetric information different agents have different information about different prospects of the world and this is one reason why we want to study financial markets just to give you a very brief history tour the general understanding in economics is that whenever markets are feature symmetric information not necessarily complete information right we do not need to know the future for sure but if everyone has the same information about the future then market outcomes are efficient so markets do function properly and they do attain the outcome that we want them to achieve however as soon as we introduce any kind of asymmetric information into markets the efficiency breaks down and this will be significant subject of our studies another specifics of financial markets is that there is a certain collection of institutional details specific to financial markets meaning that they usually are organized in a somewhat specific way so we can be less abstract when we talk about financial markets in particular as compared to the case when we talk about general abstract markets now i've skipped this section on purposes of financial markets but now we can talk about that as well so why do we need financial markets why do we need people to move wealth across time and contingencies well hopefully i have already convinced you that it is a reasonable desire for any given agent and we want to match agents who have opposing desires if i work in coal industry and you work in renewable energy then we have the opposing insurance interests desires so there is scope for profitable trade between us too more generally financial markets per se are important because they provide well because they provide forum for the trade in a given stock so trade can be consolidated in some given physical or online location rather than being dispersed across dark alleyways like drug trading weapons tray however this is not the only value for markets as no institutions but particular platforms in particular once we have a set market in place it is true that each trader can compare his private valuation against the current price where the current price can reflect the market's valuation and can thus reflect the information that is currently available to the market this means that financial markets enable transparency in this trading so they help us to aggregate the information dispersed in the society and make this information available to all agents to all the economic agents finally financial markets as exact platforms usually provide the guarantee that agents will get what they paid for so financial markets do most of them do feature this guarantee they serve as a trusted intermediary and thus they ensure some certain degree of security in trade mitigating the possible counterparty risks and other execution risks so we want to study financial markets because they are likely to be problematic and they are specific enough to enable the relevant investigation now what kind of financial markets will we be looking at in general you can separate financial markets into two types primary markets in which savings are allocated to investment so people who have the money give money to people who need the money and the examples of such primary markets are initial public offerings of stocks by firms to general populace so basically whenever a firm issues a stock what happens is that whoever invests in this stock whoever buys it gives their money to the firm in return for the promise of future payoff future dividends or future appreciation of the stock price alternatively another example of a primary market is [Music] treasuries auctions where the us government or there are analogues for pretty much any government but in treasury's auctions the us government borrows money from businesses and uh and the populace the same exact thing happens in these markets the government takes money today in a promise in return for a promise to repay this money with interest at a future date but in primary markets the bottom line is that the money that is attracted to through trade so whoever sells the assets is the final user of that money so they ensure that this money is put to good use and this money will work in order to repay to deliver on the financial promises implicit in the asset another type of financial market is secondary markets which serve to reallocate investments over savers in secondary markets trade happens between different owners and potential owners or holders of the assets so if i bought a stock at an ipo in the primary market and i resell the stock to you tomorrow this tomorrow's resale will happen in a secondary market and this trade happens in existing assets so assets that were already issued in the past and this trade typically happens on some fixed platform on an exchange or another solidified market in this course in particular we do focus on secondary markets for the most part so we will not look in great detail at primary markets which are quite often considered to be the focus of corporate finance to a larger extent because firms and government activities in primary markets can signal their information about the implicit valuations of the assets and such information is less likely to be present in secondary markets although still a large share of this course will focus on secondary markets in which such private information takes place so to fix ideas here are some examples of secondary markets that you can think of whenever we talk about any given market obviously stock markets and bond markets be it corporate bonds or government bonds all of these markets are pretty much a perfect fit for our purposes derivatives markets are also very uh relevant to what we will be doing currency or foreign exchange markets are yet another example and finally while we are actually looking at financial markets rather than commodity markets but you can think of a lot of commodity markets which will fit our purposes in particular the commodity markets which deal in futures future contracts excuse me will work quite well and these are for example oil markets or metals markets be it gold or iron most of these markets deal with the future contracts so instead of first procuring the [Music] oil or metals and bringing it to the exchange and see how much you can sell them firms sell their future products in advance in this case in this sense these commodity markets are effectively functioning as derivative markets are markets for derivatives and for that exact reason they are they can work quite well for our purposes so they function pretty similarly to financial markets now what are the questions that we would like to ask in relation to financial markets recall that our most fundamental question was how can we ensure efficiency in these markets how can we ensure that they are working properly in order to answer that global question we will of course look at different parts of the markets and see how these different parts function in particular our very important interesting question is how are market prices created the classical economic theory for the most part tells you that market prices are set by the invisible hand of the market in economics 101 in your introduction to economics you have seen demand curve the supply curve and the point at which they intersect gives you the equilibrium and this equilibrium is characterized by some volume of trade and some equilibrium price but how exactly does the market arrive to this price is the question in this course we will look at some of these foundations we'll see how at the microstructure of markets so we will see who names the price and how do they do it in particular we will see how the prices are affected by traders behavior and the environment that they have to operate in importantly we will see how traders act on their information namely if i have some advantageous informations compared to the market how exactly should i trade upon this information given that everyone else in the market is not stupid they would expect me to trade on this information so i want to fool them into thinking that i am uninformed so this may sound a little cryptic currently but you will see a little later what i mean now these first micro questions micro foundation microstructure questions will allow us to take this analysis and see how exactly we should organize the market so we will see whether market rules matter or in particular which aspects of market design matter and which do not and if market rules matter for anyone we will see some theories which will allow us to conclude whom exactly do these the do these rules better do these rules benefit and whom do they hurt in order to make a conclusion about whether market is functioning efficiently or not and whether any kind of policy helps the market or hurts it we would need some measure of efficiency so the the definition i gave you was pretty much binary right the market allocation is either efficient or not but as we all know only the safe deal in absolutes so we need some relative measures to compare two imperfect situations and to see how more how much more or less imperfect is one situation as compared to another so how do we measure if markets are working well we will be looking at a few measures but the core concept that we'll be looking at throughout is market liquidity our next lecture will be devoted to defining market liquidity figuring out what exactly it is and how to measure it but this is the core concept that will be that will serve as our measure of how well the markets work a few closely related concepts are market depth trading volume in the market efficiency even though we have already defined it we can look at market efficiency in a lot of different ways and we will see what are the possible dimensions of efficiency and finally we will talk a little bit about market stability how well can it react in response to shocks so broadly speaking this is the split at least the textbook part [Music] across the dimensions above not really the dimensions above but so we will answer these questions using different methods different approaches today and in some of the other uh actually in a lot of other lectures we will talk about the institutional details policy issues and applications so we will basically speak about how markets actually work in the real world so you'll see those descriptions and some facts about real world markets what we will do using that knowledge is we will build theories to understand and to analyze policy within the frame of those real-life institutions and possibly beyond if we want to analyze some possible changes to real-life markets finally while not the primary focus of this course we will also look at some empirical issues that arise when you want to take the theories that we develop in this course and take the concepts that we introduce and want to apply them to data or want to estimate them using the real-life data given that real-life data is quite often not ideal some challenges will be in order but we will bravely face them and we will overcome now this to remind you is a university master's level course and as such you can expect that there will be some prerequisites some things that you need to know before you actually um delve through this course in particular i expect you to know some basic finance i wanted to know what stocks are what bonds are what discounting is how can you compute the expected value of a given asset on a very basic level so i want you to not be completely lost in the financial terms that we will be using secondly we will be using a lot of tools from basic microeconomics in particular game theory there will not be anything too difficult or deep in that dimension but you need to know what a nash equilibrium is and you would want to know some you would want to be familiar with some of its extensions for example sub game perfect nash equilibrium for the case of sequential move games or bayes nash equilibrium for the case of incomplete information games or perfect base in equilibrium for the combination of the two once again you do not need to have a deep knowledge of game theory but you need to at least have heard about it at some point finally some knowledge of math is in order in particular you need to know some basic calculus optimization theory and probability theory again all of this is needed on a very basic level for example from probability theory the two things you need are base rule and how to compute a mathematical expectation of a random variable from optimization theory all you need is knowledge of how to find a maximum of a smooth function on a compact interval so no particularly esoteric topics will be used but some background is required finally just a point of order is that this course explicitly focus on rational models where we constrain our economic agents in our models to behave rationally in the economic sense of view there is a complementary field of behavioral finance which you may also be which you may also explore if you are interested in in finance in general because as i said behavioral finance provides a very complimentary point of view on some of the related issues on some of the same issues even this concludes the introduction and now let us well continue with the introduction right this was a very broad overview of how the course will work and now let us go a little uh closer to details and explore some of the core concepts that we will be using throughout this course we will begin with prices price theory is something that is very fundamental to economics again in the introduction to economics one of the first things that you one of the first concepts that you saw was market price and in those models we usually think there is one price at which trades happen in a given market and in particular there is no arbitrage meaning that no given agent has access to two different markets which have different price for the same asset so the agent can buy asset on one platform and sell it on another platform now this is neither of this is quite true in the real world firstly the law of one price does not hold exactly if one given asset be it a financial asset or really any given item if any given item is traded on more than one platform it will likely be traded at different prices slightly different but different nonetheless and this obviously enables arbitrage but the difference in these prices is made such that is usually such that such arbitrage is unprofitable however there is another dimension in which law of one price is violated in financial markets in particular in particular in even if we focus our attention to any single financial market you will have more often than not not one but two prices in that market you will have a bid and an ask price a bid price would be the price at which you can sell your asset to the market and an ask price would be the price at which you can buy the asset from the market and it will typically be the case that an ask price will be above the bid price so that if you want to buy the asset and then immediately sell it the profit from such a round trip would be negative so this is a requirement of no arbitrage condition and within any given market such arbitrage typically holds now the difference between the bid and the ask price is called the bid ask spread and a lot of this course is devoted to analyzing how exactly this spread is determined and what drives it why are we so interested in this spread well the answer is simple if there is such a price at which you can neither buy nor sell the asset the market outcomes are likely to be inefficient because if you have such a if you have a valuation for an item which is between the bid and ask and there is another agent whose valuation for the item is also between the bid and ask so inside the spread and the two of your valuations is are different there can be scope for profitable trade between you and that agent but due to prices being [Music] due to your evaluations being inside the spread neither of you can neither buy nor sell to one another at a mutually acceptable price so the existence of the spread is a impediment to market efficiency the existence of the spread is a friction that our market faces so we will our investigation of market efficiency is actually intimately connected to the investigation of the bid ask spread and even if you have never traded in financial markets if you have never seen financial market quotes chances are you have encountered bdesk spread in real life if you have ever traveled abroad and you had to buy or sell foreign currency you know that the prices which you can buy the currency are very different from the price at which you can sell this currency and those are typically there is quite a significant wedge between the two the idea here is very similar this however is an example of how uh stock market quote can look like so this is a information sheet for google stocks from january of 2015. i of course i could update it for 2020 data but it's not that much different so even here you can see that even though there is one outlined price 518 dollars and four cents per stock the actual prices are quite different the actual prices at which you can trade are different in particular the market bid is 5 18 and 80 cents and this is the price at which you will be able to sell any extra google stocks you might have while the ask price is 520.95 so if you want to buy stocks you will have to buy at this price and you see that there is a wish between the two in this particular case both the bid and the ask are above this outline price and this can be connected to the fact that this outline price is quite often the price of the last trade so this is the backward looking price while the bid and they ask are forward-looking prices these are prices at which you can trade in the future and in this particular case the divergence between the two can be driven by the fact that some information got revealed in the interim which led to everyone agreeing that google stocks are worth more than 580 dollars and four cents there's a lot of other data you can see in this information sheet you can see the volumes of trade in a given day you can see some ranges that prices have taken in the past day or a year to estimate the volatility of the price so let us go back to one of the fundamental questions we asked that price of the google stock the 518 dollars and four cents where did it come from who decided that the google stock was worth 518 dollars and four cents today in general the asset pricing theory tells us that this so to say fundamental value of the stock the actual amount that it's worth if you can even objectively define it comes from the stream of future incomes that the stock can give you so either dividends or price appreciations and these future incomes are driven by a lot of different factors a lot of different managerial decisions within google so they'll be driven by how much research and development google does how well it is governed how well its marketing department works what is the competitive environment that it faces and many many many many more so you can argue about the fundamental value of the stock given the combination of these factors all day long you can argue about how these factors aggregate into a single value for a very long time what we will do in this course is not this so we will not discuss how exactly to determine this fundamental value what we will do instead is we will take the fundamental values given and we will analyze how this fundamental value translates into the market prices so we will ask whether market prices reflect this fundamental value accurately or there are any systematic deviations in particular the concept one of the concepts that we will look at is price discovery and this has to deal with how how much information about the fundamental value can be extracted from market prices or conversely how quickly does any new information about the fundamental value get incorporated into the market prices now so far in your previous economics courses you have been used to analyzing some abstract long run equilibrium allocations and prices right so you assume that there was some market demand market supply which are all likely composed of a lot of different agents and you said that well if these agents interact with each other which they will probably do in a long enough perspective then market will [Music] the market will settle down on some given price and after all trades are said and done a given allegation will establish well in this particular course we once again we zoom in on that interaction we ask how exactly those prices and allocations are established and the important step in this analysis is understanding that not everyone who wants to trade in a given asset is present in the market at the same time so going back to our google document spreadsheet daily trading volume was about 2 million stocks 2 million times 500 gives us about 1 billion dollar in daily trade in google stocks and if we have if we sum up those volumes over month or a year you will get well proportionally more but is it true that we can analyze all of the agents who trade google stock across a year and we can pull them together in this econ 101 analysis can we aggregate them all in single market demand curve and market supply curve probably not because if i want to trade a stock today it is not guaranteed that i will still be willing to trade in this given stock tomorrow so there is a given disconnect in times at which the agents trade and if we take the slice of the market for any given time period we will see that there is no longer a huge infinity of agents on either side of the market but actually there are only a few agents again on either side of the market only a couple of agents willing to buy a few more willing to sell or vice versa and so these agents are interacting with each other but they are not directly interacting with all of the other people who want to buy or sell billion dollars worth in google stock in particular this kind of limitation limited capacity of both supply and demand in the market at any given time can lead to temporary imbalances so we can not really guarantee that the supply of the asset at any given time will equal the market demand at the same time so you can have the situation in which you have too many sellers at some point in time which will result in the fact that price in that short time period will be lower so if a lot of people want to sell today they will compete with each other driving the price down which will mean that a market price becomes lower but once this imbalance is eliminated once all of these sellers got to sell or once more buyers arrive the prices do return back to their you can say long run level so given that we asked a lot of questions about the price uh how it translates how well it reflects the fundamental value and how quickly does it incorporate any information about the fundamental value we need to analyze all of these market imbalances another manifestation of this limited capacity of the market is that it is it might be quite costly to execute large orders quickly so if you are the only seller of a given stock in a given time frame you only face a limited number of potential buyers so if you want to sell a lot and you try to sell this huge amount within the short time frame then you'll probably have to agree to a low price once again if there is a too much supply this drives the price down however if you if your trade is not urgent so if you want to sell a lot of the asset but you do not need to do it now you can wait a few seconds a minute an hour then you can spread your trade over this time frame which will not create as heavy an imbalance and which will have less of an adverse effect on prices so if you're willing to spread your trading time you will get a more favorable price on average all of these effects are related to the liquidity of the asset which is the concept that i've already mentioned liquidity is slightly again abstract concept according to wikipedia market liquidity is the market's ability to facilitate an asset being sold quickly without having to reduce its price very much and slightly vague definition but you can see what it means so if you are the only seller in the market and you want to sell a lot and you want to sell it now then basically liquidity can on a very surface level tell you how much of a discount will you have to take in terms of the price as compared to the fundamental value so if you will have to sell very cheaply it means that the market is not very liquid right now or vice versa if the market is very liquid at any given point in time means there are a lot of buyers in the market and a lot of sellers in the market at any given time which means that any order you throw at the market will be absorbed by the market without any heavy effect on the price so for example if you want to sell a google stock the market for those is pretty liquid once again 1 billion daily trading volume but if you want to sell a stock for a small danish company you will likely have a harder time doing that because there are not so many traders willing to buy those at any given point in time once again in the next lecture we will develop some measures of liquidity and we will talk about what exactly is liquidity and how to measure it and a lot further on in the course we will argue that sometimes more liquid assets may be more valuable so not only is liquidity measuring how far does the price deviate from the fundamentals in response to trades but also the feedback might go the other way around and liquidity may itself be a factor in the fundamental value of the asset now market depth is a closely related concept and the distinction between depth and liquidity is very subtle in particular you can consider market depth as one of the aspects of market liquidity so market depth in particular measures how big of an order is required to change the price of an asset by a fixed amount so liquidity in general can measure how much of a discount uh respective to the fundamental value will you have to take uh for your trade in order to sell the asset and there are a lot of ways in which you can measure that market depth is more precise it shows you how exactly does this discount change with the order size so in principle you can see market depth as a first derivative of market liquidity with respect to the order size why do we care about market depth well for all the same reasons that we care about market liquidity in general observing market depth may be a little more difficult than observing liquidity because even though previous trading prices are quite often observed and you can observe the best quote on either side of the market at any given point in time but it is sometimes harder to know what will be the quotes beyond this best one so these quotes are only valid for a specific amount of stocks and if you want to buy or sell more than this amount you will have to go deeper into the market and there is no knowing which price is that height so these are some of the core concepts that we will be talking about uh in this course once again we will be returning to most of them and we will be defining them more precisely later in the course for now however let us also talk a little bit about the institutions in the financial markets so how exactly are these markets organized and once again we will be primarily talking about the secondary market now you can very roughly split financial markets into two categories according to how trade is organized in this market on the one hand you will have order driven markets where orders are submitted into a common limit order book and there is some person or algorithm matching these orders and they execute against one another so if you're willing to buy the asset then you your order is matched with that of some trader who is willing to sell the asset on the other hand you have dealer markets where all trades happen through a centralized intermediary so when you want to buy or sell you do not necessarily deal directly with another trader on the other side of the market but you are rather dealing with the market appointed dealer or the market maker and this dealer is obliged to buy or sell any given amount at a given at some prices and this dealer sets prices over time so as to manage their inventory and their profits of course so looking at both of these categories in more details let us start with order driven markets and you can well very roughly see these markets in as a two-stage process so first orders are submitted then trades are arranged given these orders now the frequency at which these two stages are repeated can vary in particular you can have continuous markets in which effectively this loop occurs in at any given point in time so in continuous markets orders are persistent meaning that once you submitted the order to the market it is uh it stays there in the limit order book until it is executed or until you cancel it a converse to continuous auctions continuous markets is given by the call auctions in which this loop occurs with a given frequency which is not infinite so there can be a given time frame such as a minute an hour or something on other magnitudes and first of all orders are submitted during this time interval but no trade is taking place during this time interval and once the period ends the trades are arranged given all of the orders that were submitted during the time period so these are call auctions another dimension in which order driven markets can differ from one another is in terms of the order precedence so if there are many markets if there are so many orders on any given side of the market which is probably the case unless the market is very illiquid if there are many orders which is the order in which they are executed no pun intended so if there are many people willing to buy who gets to buy first whenever a seller arrives quite typical and i would dare say first order priority is the price priority so among all buyers the one who gets to buy is the one who offers the highest price is the one who offers to pay the most for this product but then what happens if two different buyers are willing to pay the same and this same amount is the highest amount in the market how do you split between these two buyers how do you break the tie well second order priorities can vary from market to market and one option is time priority meaning that if two traders are willing to pay the same amount for the asset the one who submitted their order first is also the first to execute first in first out another dimension of uh order precedence that can be relevant is the visibility of the orders in particular limitary books are often organized or sometimes organized in such a way that you can choose whether your order is visible to other traders when they submit their order or if your order is hidden so it is not shown in the limit order book but whenever a profitable a a profitable trade can be arranged your order is still counted whenever such an opportunity exists it is typically the case that visible orders are executed again sorry are executed before the hidden orders so visible orders have the priority again for a given price moving on another dimension in which or driven markets can differ from one another is the price interval in particular when the trades are crossed when the trades are arranged given a given a given set of orders do do you cross them and set the one price which fits everyone so like in the intro to econ you have this market price after you cross the demand and supply and you force everyone to trade at this same price or do you allow for discriminatory pricing in which different trades can happen at different prices beyond that there can be some heterogeneity in whether price is directly determined from the orders or if the price is taken from for example some other exchange which is sometimes the case when the asset is traded on more than one exchange finally markets are very heterogeneous in terms of what happens at the beginning at the end of the trading day for example even if uh trade is organized via continuous trading during the day it might still be the case that during the first 15 minutes no trade takes place and there is some call auction happening the pre-trade so to say and such pre-trade auction happens in many markets sometimes the same happens at the closing of the market in which 15 or 30 minutes before the market is closed all trading stops and all orders are accumulated into one limitary book and then at the closing times all of these orders are crossed with one another so opening closing hours quite often have some special trading rules and these rules may be different across different exchanges now when talking about market orders that can go into the limit order book there can be different kinds of orders that we can talk about for the most part we will be talking about two namely limit orders and market orders and for this discussion i would like to think about a continuous market in which trades are cleared whenever there is an opportunity for profitable trade to be cleared in such a market a limit order would specify a quantity and a price meaning that a limit order would say something like i would like to buy 500 shares at a price of no higher than 40. in your order a limit order like this would be submitted to a limit or a book and it would stay in the book once again until someone would be willing to sell you these 500 shares at a suitable price or until you cancel it these limit orders are quite often cross against market orders a market order specifies the quantity and it says i would like to buy or sell this quantity immediately at the best available price so if you have submitted a limit or saying that you would like to buy 500 shares at a price no higher than 40 then it can be executed if either someone submits a sell limit order saying that they would like to sell 500 shares at uh some price which is lower than 40. or if we market if a market sell order comes meaning that some trader would say i would like to sell 500 orders at the best available price and so if your limit order features the best available price this is the match that will happen so market orders are executed immediately at the best available price while limiter books limitor sorry limit orders stay in limitary books until a suitable trading opportunity arrives now we when we will be talking about such order driven markets we will discuss what kinds of traders decide to use which orders and one thing that we will discover for example is that patient traders are usually more passive in that they use limit orders they are willing to wait in exchange for getting a better price on their trade and we will say about limitors that they provide liquidity to the market they give these trading opportunities to other traders at the same time the impatient traders are more aggressive they use marketers because they want their trade to be executed now because they are impatient so they take liquidity from the market they deplete the limit order book using their market orders and so we have already talked about uniform versus discriminatory pricing but to emphasize this again generally the pricing is discriminatory in at least some sense in particular the price that you will get will almost often depend on when exactly you decide to trade because this will define whom you are trading against what is the state of the market at that given time so there is always some degree of discrimination now when we talk about two different markets two different orders that were submitted at the same time to the same market whether these would be executed at the same price at the uniform price or their individual discriminatory prices this can vary from market to market now some examples of continuous limit or book exchanges are new york stock exchange so one of the largest stock exchanges in the world it's either the top 1 or top 2 with nasdaq as its partner and new york stock exchange has both electronic and outcry markets it is one of the very few remaining exchanges who that still has open outcry market i am not fully confident that it is still there but i believe that outcry market was in place as re as recently as five or ten years ago in europe continuous or given markets are given by london stock exchange or bats in my belief barcelona or euro next which has many different venues all across europe so this is a continuous limiter book trading is a very popular way of organizing markets now moving on to call auctions these are auctions in which as i said trade happens at a given frequency so first orders are collected in some batch and after a certain number of hours are collected over a fixed time period they are all cleared simultaneously now the price of such a trade is chosen such that to maximize the number of executed orders given the order submitted to the limitary book notably in this case you will have uniform pricing so all orders in the batch will trade at the same price be those orders to buy or to sell the asset now as i said this uniformity only applies to the trades within the given time frame but if you trade in different periods you will still face different markets different limiter books and probably discriminatory prices so in theory this uniform pricing gives us some very good efficiency properties right because we discussed that inefficiencies arise because the price of the asset deviates from its fund from the fundamental value of that asset and prices deviate from uh for buy and sell orders use the b desk spread so it seems like in the presence of uniform pricing there is no spread so all trade trading should be efficient but there are some drawbacks to call auctions as well in particular the trivial one is that trades happen slower than in the continuous market so some impatient traders may not be willing to trade in call auctions which can have various long-running repercussions such as lower trading volume on aggregate other traders not willing to trade because trade volume is too low and the market is too liquid and so on and so on so absence of impatient traders can have long running repercussions now examples of call auction exchanges are a lot of major exchanges nasdaq is one now lse also has and euronext also have call auction exchanges in addition to continuous trading which may operate in parallel for some assets so most of these exchanges operate call auctions together with one of the other trading methods meaning that in parallel with either continuous trading or in parallel with the dealer i've already mentioned the main distinction but to reiterate once again in order driven markets the idea is that traders are matched directly with one another so you can buy the asset only if someone else is willing to sell the assets at the very same time in dealer markets the situation is different in particular there exists the central intermediary the market maker the dealer who is tasked with buying the asset from whoever is willing to buy and from selling the asset to whoever is willing to sell and the dealer can set the prices so as to approximately equalize the demand and supply so the dealer quotes a bid and ask price which are typically valid only up to certain number of shares and if you want to trade a lot if you want to trade large amounts against the dealer you would likely have to negotiate with them individually regarding the price that they can offer you now this dealer will likely quote the positive bid ask spread so the dealer will not be willing to buy and sell at the same time at any given at the single price because they need to eat they need to generate some trading profits in order to make all of this worth it but at the same time if the dealer makes this bds spread too wide then some of some competing dealers can attract all business to themselves so if dealers are competitive they will have incentives to make their bid ask spread narrow enough to attract some given trade but while still generating some trading profits necessary for subsistence so a reasonable question to ask here is how competitive would the prices be in any given organization of the market in any given mode of interaction between the dealers or between the traders and the dealers now dealers profits are not are needed not only because dealers are such self-centered profit maximizing entities but simply because they have some costs in their operations so firstly they need to incur some transaction and operation cost they will be subject to inventory costs because they will likely end up with some positions in the asset they will end up either having some positive stock of the asset or owing some positive amount of the asset and if the price of the asset changes while the dealer has this position it may give it may result in a call in a loss for the dealer it may also result in a profit but it rarely will finally the dealers will also have to deal with the adverse election so dealers will have to deal with having to trade against more informed counterparties the main example of a dealer exchange is nasdaq as i said either top one or top two stock exchange in the world by trading volume so you can say the dealer exchanges are also quite quite prominent now moving on from the distinction between order driven markets and dealer oriented markets you can also vary you can also class classify markets according to how they are organized and how strongly they are regulated the most formal and regulated markets are exchanges so stock exchanges first and foremost or other kinds of exchanges and these are organized exchange venues so new york stock exchange nasdaq london stock exchange are all in this category and they typically not only offer a place and a time to trade but they offer a lot of side services so we mentioned that one purpose of the market existence is providing security to the trades and this is one of the services that these exchanges provide so they [Music] typically provide clearing and settlement services ensuring that you pay for what you bought and you get the item that you actually bought an indirect service provided by these exchanges is liquidity and stability so exchanges are interested in markets functioning smoothly because it allows them to attract the business so these mark these exchanges will by themselves uh employ specialists or market makers in order to provide liquidity in the market and to stabilize the particularly sharp market fluctuations and finally we have also discussed that uh exchanges yield in some degree of transparency so they make past trades observable they make quotes more easily available to potentially interested traders so transparency is one of the perks that exchanges bring through their existence now a counterpart to exchange trading is over-the-counter trading or otc trading and broadly speaking uh you can classify otc trading as everything that is not traded through the exchanges so if we meet in a dark alley um and i sell you a stock this would be an example of over-the-counter trading so these are off-exchange venues in current days otc venues are quite often also very formalized and very organized platforms so they differ from exchanges in a very slight and subtle ways mostly in terms of the requirement for company transparency for the transparency of companies financial reports so otc platforms uh the decentralized ones do not require firms to make so much financial disclosure as the big exchanges but of course this perk for the firms comes with corresponding benefits namely that traders will likely not be willing to trade in such non-transparent stocks otc platforms may vary in their liquidity provisions so they may have less incentives to provide liquidity but in the big picture in the big scheme of things they are still quite similar to the exchanges so the distinction may be quite arbitrary and subtle finally one thing to point out here uh is dark pools of liquidity so these may or may not belong to otc platforms depending on the classification you use but dark pools of liquidity are usually classified as some internal platforms for example a large investment bank can match the orders of its clients against each other instead of forwarding these orders to the exchange and such dark pools of liquidity have risen quite prominently in the recent years in the recent 10 20 years and they have been one of the subjects of recent financial regulation in both u.s and the european union so we will talk about those a little more when we talk about market transparency so this was the classification or two different classifications of different financial markets and we saw that markets can generally differ in a lot of different dimensions so what should we look at when we want to compare these markets what are the factors that we would that we would want to focus upon and this of course all depends on whose perspective you want to take if we see us as a regulator who wants to devise the rules for these exchanges to operate then you would like to ensure competition on all sides of the market because it typically results in efficient allocation but typically efficiency would be the part that you would be most interested in all the various ways in which the factors that we mentioned the degrees of heterogeneity that we mentioned affect liquidity effect efficiency i'm sorry on the other hand if you take the perspective of the trader then you don't really care about efficiency right you don't really care whether the assets are allocated efficiently in the end whether you get to sell your asset to whoever values it the most but rather you would care about selling your asset at the highest value you would want to get the best bang for your buck or in this part in in case you are selling the asset it will be the opposite right the best buck for your bank so if you are a trader you would care about liquidity in the market because liquidity basically determines how big of a discount you need to take when you are selling the asset you would care about the transparency in the market because transparency determines how well you can actually determine how much your asset is worth and how much you can sell it for relatedly you would care about the information available in the market but in this case not the information you can directly observe but rather about the information that you can infer from for example market quotes so you see that different agents in the market care about different different aspects different dimensions different measures of market operation and we will look at all of those when we get to analyze the models but to take a second to explore in slightly more detail the agents that we have in the market the most we will put the most focus on the three following groups of the agents first we will be talking about traders or investors who will be the in essence the end consumers the final consumers or suppliers of the asset so these are economic agents who want to hold the asset who want to assume some position in the asset beat long or short position we can classify these traders in in different dimensions so firstly [Music] from the background point of view you can distinguish retail investors and institutional investors retail investors are individual people who basically have an excess of savings and they would like to invest their money in the stock market institutional investors on the other hand are companies who have some funds wherever they may be from and they need to once again invest these funds into stock market an exam the examples of such institutional investors can be pension funds who need to manage people's savings or these can be mutual funds who collect money from the people who are not willing to invest in stock market directly who do not want to buy the stocks but rather they invest in the mutual fund which manages uh the portfolios and the mutual funds then invest these money on the people's behalf finally you can think of some private equity funds or all the various other kinds of for-profit traders so the distinguishing feature between these two categories is that retail investors are well let's say amateurs investment while institutional investors are usually professionals so these are people who get paid for devising the optimal trading strategies another dimension of heterogeneity in the investors that we'll quite often be talking about is informed versus the uninformed investors in particular we will be talking about whether the trader is trading based upon some private information that they have about the value of the asset and this private information is not available to the rest of the market excuse me or are these traders completely uninformed and they have the same information about the mark about the asset value as the market does and they trade for a variety of other reasons so they are trading not because the mar the tr the let me say that again they are trading not because the asset is mispriced compared to their perceptions but rather because they have a particular idiosyncratic need to trade in that asset so going back to our example if you work in coal industry you want to buy um a stock of renewable energy companies not because you have some difference of opinions compared to the market as to how much profit will this get you but rather you buy this in order to balance your portfolio so you have this idiosyncratic need to buy stocks of renewable energy companies and you do not necessarily have any informational advantage over the market often we will equalize retail investors to uninformed and institutional investors to informed but there is significant special case namely the pension funds who are institutional investors but are typically perceived as being uninformed investors so they do not have huge research departments saying where they should invest in but they have [Music] a lot of funds that they need to manage so this was an overview of traders or investors and there will be two different categories of intermediaries that we'll talk about we have already discussed dealers or market makers who are the intermediaries who are basically matching orders of different traders and supplying liquid to the market when there is none so dealers and market makers are the agents who are willing to buy or sell the asset when nobody else is and the third third category of market players that we will look at are the brokers so the brokers stand between traders and the investors if you think of the trading floor right so the old school stock exchange where there are a lot of people in suits shouting at each other then you will have a dealer in the center and brokers would be trading with the dealer you as a retail investor as a regular person you would not have access to the dealer because the dealer is a busy person standing right in there right there in the trading floor so what you would want to do if you needed to trade would be to call your broker for example an investment bank and tell your broker what is the trade that you're willing to execute and then the broker would relate that order to the market now we will very briefly touch upon different agency problems and conflicts of interest between traders and the brokers but we will not explore this conflict in great detail regulation so we have seen what markets can be what we should care about what are the players in the market how can we as regulators affect these markets and change market outcomes well first of all what are our goals the goals are pretty simple right we want to arrive at efficient allocation but if you want to split it into more micro goals then it will be potential protection against insider traders on the one hand so you would want to protect the uninformed traders against being picked off by those who are more sophisticated than them by those who have informational advantage over them but at the same time you want to keep the information flow running you want prices to be efficient meaning that you want to enable price discovery but price discovery is impossible without the informed traders so price discovery is only possible if informed traders are willing to trade and thus contribute their information to the market so you want to trade off these two aspects protection of uninformed investors and price discovery in the market another goal is stabilizing the market so in case of large sudden shocks or halts or short sale bands you want to smooth down the drastic uh drastic the periods of drastic volatility in the market and once again in order to ensure the agents one another in order to insure the agents yeah from these satin shocks since most economic agents are risk averse to one degree or another this would make the agents more willing to trade and would improve liquidity would improve efficiency and so on conversely speaking if agents expect that there can be large shocks in the market they would be more reluctant to trade which would be an impediment to efficiency so that is why you would want to stabilize these [Music] periods of large volatility and more generally you want to select the optimal trading structure on any given market so for assets the underlying financial assets are in themselves very heterogeneous some are some have large markets so a lot of people willing to buy or sell some of them have thin markets and you want to select the optimal trading structure for all of those uh assets popular and not volatile and not i guess these are two main dimensions in which assets can be heterogeneous how can you achieve these goals what methods do you have well some examples are we have already seen a lot of those right we have seen what are dimensions of heterogeneity of the markets and u.s regulator can quite often have control over these degrees of heterogeneity but to be more particular you can require of you require routing force between markets so if markets are fragmented if the same asset is traded on many different exchanges then you can require some degree of interaction between these markets require as in legally or you can impose some transaction taxes or subsidies you can impose some margin requirements so to require some certain degree of collateral in order to ensure the agents and to ensure the platforms against counterparty risk once again to make the trading less risky for everyone who trades with a given agent finally you can impose various policies on algorithmic and high frequency trading high frequency trading not high frequent trading because these again affect the market in non-trivial dimensions finally you would want to regulate the competition between exchanges between platforms because here the trade-off is once again non-trivial typically liquidity begins liquidity so i want to trade on the platform where everyone else is already trading because then i have more opportunities to trade this may stimulate the natural monopoly so it is more efficient to have one large market than the few small markets because such kind of fragmentation goes against all the goals of the markets in general that we've seen however at the same time competition between platforms can improve the terms of trade that are offered to the traders so if you have one monopoly exchange that it would likely charge high transaction fees while if two smaller platforms compete with one another they would drive each other's transaction fees way lower the monopoly level so this is an open question on how much competition should we require among amount exchanges should require order routing which has its own perverse effects on competition should regulators require price transparency so to reduce the informational advantages that any given exchange has should we foster competitive market making all of these are open questions that we'll touch upon these are some statistics on real world exchanges and i believe these might be quite old again from maybe five years ago 2015 or so so these are stock exchanges by volumes of trade in billions of us dollars as i promised you new york stock exchange and nasdaq are the two largest exchanges by far so they are about four or three and a half times bigger than the next biggest exchange which is the japan exchange group but overall there are quite a lot of exchanges all over the world this graph i believe does not feature any more u.s exchanges but there are a lot of asian and european exchanges in here so the u.s exchanges are pretty concentrated there are two while european and asian are slightly less solvent it is an open question for us as regulators which is the better structure which is the better market structure which results in better market outcomes so this is the point that we should i would like to finish today as exercises for the next class you can begin by feeling a little immersed into the world of finance and find share prices bid and ask prices for some of the popular stocks such as facebook or microsoft a more interesting challenge would be to see which stock exchanges do these prices come from and you can figure out which stock exchanges are these shares traded on i will give you a hint there are many such exchanges secondly you can read the article about the london metal exchange which is one of the last trading floors the physical trading floors in the world and i believe the last physical trading floor in europe and the open question for this article is what is the value of keeping the this open outcry trading floor in the age of digital trading what is the value we have in this physical presence rather than moving this train digital as a reminder the link to this article is in the course files there is a list with links to all the articles finally if you have the textbook i invite you to solve exercises from 1 to 3 for chapter 1. and these deal with this give you basically an example of continuous and call auction markets and they give you a certain orders and you can compare market outcomes in case of continuous trading versus the call auction with that i sign off for today and we'll see you in lecture two you

hello and welcome to financial markets microstructure this is a master&#39;s level university course that was read in the university of copenhagen in the spring of 2020 like many other courses especially university courses in that time period this one was affected by the outbreak of the covet 19 virus which led to most of the scores being read online in particular the 10 out of the 16 lectures and 3 out of 5 exercise classes were held as live streams and the recordings of these classes were uploaded to youtube and these are the recordings that you will get that you will get to see if you follow this if you decide to follow this course given that relatively few classes were missing i decided to re-record these classes separately not the exercise classes but the lectures at the very least and uh complement the existing recordings to a full course experience now i would like to warn you that these recordings will be one pass with no editing whatsoever not because i do not want to do better but because i would not want to create any false expectations about the quality of the second half of the course and not create a sudden quality shock all of the materials for this course can be found on my personal website and i by the way is igor starkov an assistant professor at the university of copenhagen so on my website let&#39;s start over the site in this section on teaching you can find the slides for the course as well as problem sets in the exams in these lectures i give exercises at the end of any given lecture and those quite often involve reading some of the articles not the academic articles quite often but rather magazine articles from journals such as the economist bloomberg and etc the course files on my website include the full reading list which gives you exact links to those articles as i mentioned the course files also include the problem sets larger more cumulative problem sets that you can do to exercise the knowledge you obtained in lectures and there is also the final exam for the course it is not available as of now at the point of view of the at the point of this recording but i will upload it sometime during the summer of 2020. this course is largely based on a single textbook and this is a textbook by terry foucault marco pagano and ilse hoyle and this is a great textbook on market microstructure this book was published in 2013 so it is relatively recent and for the two-thirds of the course we will mostly be following this textbook now it is completely understandable if you would rather read the textbook than listen to this not very interactive podcast uh so if you would rather skip anything that you can easily read in the textbook then i invite you to start at lecture 11 at the second half of lecture 11. where the course switches from the textbook to research articles and at that point the course becomes a little more creative it not simply retells the articles but it regurgitates to some extent those articles and present them in a more digestible form unlike again the first two thirds were i more or less just retell you the textbook so this was the logistics of this course and there was obviously not that much given that this is an online youtube recording so let us now get to the course itself and we will start by figuring out what is this course about exactly so this is a course on financial markets let us take a step back and figure out what are markets in general and why do we want to study them so the first question is what is a market webster dictionary defines no i guess not that but a market broadly speaking is a set institution in which property rights are exchanged between different economic agents similar way to saying that is a market is a place where people trade and the place can be defined relatively broadly so it can be a physical place like a market square in a town or it can be a digital platform or it can be a cumulative set of abstract um abstract concepts let&#39;s say for example if you think of any shady markets like drugs market weapons market there is no physical place or online platform for those but rather we mean those in their very ethnic ethereal senses so why do we want to study markets as i said the whole point of markets is that they enable the exchange of property rights between different agents and these exchanges happen in such a way as to well more often than not improve market welfare improve social welfare improve the total surplus in the society because the way it usually happens is the items change hands from the person who values it little to a person who values it more otherwise the trade is unreasonable at the very least this is the kind of trained trade that we would like to see so we would like property rights to be allocated efficiently in the society meaning that for any given item we would ideally want the person who values it the most to own this item and in order to achieve this allocation we need to ensure that markets function smoothly that the exchanges do occur and the exchanges happen in a efficient way that items change hands even only if this leads to an increase in social welfare if and only if it is traded from the person who values it little to the person who values it more so we would like to study markets to ensure how exactly we can ensure this efficiency now what is so special about the financial markets in particular let us again begin with asking what exactly are financial markets how do they differ from the standard market well financial markets are obviously just markets for financial assets these are markets in which a particular class of items is traded and financial assets are special in that you basically just buy money with money right if you think about any example of financial assets such as stocks bonds derivatives you pay the money now to own to own one of these assets which will the sole purpose of which asset is to yield you more money in the future so why to do that two reasons firstly you might want to reallocate your wealth over time in case you&#39;re buying some kind of riskless asset you are investing your money away in order to obtain more money later alternatively you might want to reallocate your wealth across different contingencies of the world simply speaking there are many different scenarios of the future there are many different possibilities which may or may not occur and your financial situation may be such that in some of these contingencies you obtain a lot and in some of these contingencies you obtain little for example if you are working in the coal industry you your well-being will be okay if the renewable energy does not pick up well if it does pick up then you will likely lose your job and your wealth in that contingency in that version of the future will be diminished so you may want to ensure against that and move your wealth across these two contingencies that i just mentioned and in this particular example an optimal investment for you would actually to would actually be to invest in some of the renewable energy companies because such investments would only pay off if renewable energy picks up and by investing some share of your existing wealth into those assets you would equalize your wealth you would ensure your future wealth across different possible scenarios of the world so these are financial assets they allow you to move wealth across time and contingencies and the important aspect of this specifics of the fact that financial assets move well the cross contingencies across different versions of the future is that different people may have different information about how likely these different contingencies are in particular if you are working in the coal industry you might have a better insight as to what is the current state&#39;s current state of the oil of the coal industry while if you&#39;re working in renewable energy you are more informed about what are the actual prospects of the renewable energy so these markets feature a lot of what we will call asymmetric information different agents have different information about different prospects of the world and this is one reason why we want to study financial markets just to give you a very brief history tour the general understanding in economics is that whenever markets are feature symmetric information not necessarily complete information right we do not need to know the future for sure but if everyone has the same information about the future then market outcomes are efficient so markets do function properly and they do attain the outcome that we want them to achieve however as soon as we introduce any kind of asymmetric information into markets the efficiency breaks down and this will be significant subject of our studies another specifics of financial markets is that there is a certain collection of institutional details specific to financial markets meaning that they usually are organized in a somewhat specific way so we can be less abstract when we talk about financial markets in particular as compared to the case when we talk about general abstract markets now i&#39;ve skipped this section on purposes of financial markets but now we can talk about that as well so why do we need financial markets why do we need people to move wealth across time and contingencies well hopefully i have already convinced you that it is a reasonable desire for any given agent and we want to match agents who have opposing desires if i work in coal industry and you work in renewable energy then we have the opposing insurance interests desires so there is scope for profitable trade between us too more generally financial markets per se are important because they provide well because they provide forum for the trade in a given stock so trade can be consolidated in some given physical or online location rather than being dispersed across dark alleyways like drug trading weapons tray however this is not the only value for markets as no institutions but particular platforms in particular once we have a set market in place it is true that each trader can compare his private valuation against the current price where the current price can reflect the market&#39;s valuation and can thus reflect the information that is currently available to the market this means that financial markets enable transparency in this trading so they help us to aggregate the information dispersed in the society and make this information available to all agents to all the economic agents finally financial markets as exact platforms usually provide the guarantee that agents will get what they paid for so financial markets do most of them do feature this guarantee they serve as a trusted intermediary and thus they ensure some certain degree of security in trade mitigating the possible counterparty risks and other execution risks so we want to study financial markets because they are likely to be problematic and they are specific enough to enable the relevant investigation now what kind of financial markets will we be looking at in general you can separate financial markets into two types primary markets in which savings are allocated to investment so people who have the money give money to people who need the money and the examples of such primary markets are initial public offerings of stocks by firms to general populace so basically whenever a firm issues a stock what happens is that whoever invests in this stock whoever buys it gives their money to the firm in return for the promise of future payoff future dividends or future appreciation of the stock price alternatively another example of a primary market is [Music] treasuries auctions where the us government or there are analogues for pretty much any government but in treasury&#39;s auctions the us government borrows money from businesses and uh and the populace the same exact thing happens in these markets the government takes money today in a promise in return for a promise to repay this money with interest at a future date but in primary markets the bottom line is that the money that is attracted to through trade so whoever sells the assets is the final user of that money so they ensure that this money is put to good use and this money will work in order to repay to deliver on the financial promises implicit in the asset another type of financial market is secondary markets which serve to reallocate investments over savers in secondary markets trade happens between different owners and potential owners or holders of the assets so if i bought a stock at an ipo in the primary market and i resell the stock to you tomorrow this tomorrow&#39;s resale will happen in a secondary market and this trade happens in existing assets so assets that were already issued in the past and this trade typically happens on some fixed platform on an exchange or another solidified market in this course in particular we do focus on secondary markets for the most part so we will not look in great detail at primary markets which are quite often considered to be the focus of corporate finance to a larger extent because firms and government activities in primary markets can signal their information about the implicit valuations of the assets and such information is less likely to be present in secondary markets although still a large share of this course will focus on secondary markets in which such private information takes place so to fix ideas here are some examples of secondary markets that you can think of whenever we talk about any given market obviously stock markets and bond markets be it corporate bonds or government bonds all of these markets are pretty much a perfect fit for our purposes derivatives markets are also very uh relevant to what we will be doing currency or foreign exchange markets are yet another example and finally while we are actually looking at financial markets rather than commodity markets but you can think of a lot of commodity markets which will fit our purposes in particular the commodity markets which deal in futures future contracts excuse me will work quite well and these are for example oil markets or metals markets be it gold or iron most of these markets deal with the future contracts so instead of first procuring the [Music] oil or metals and bringing it to the exchange and see how much you can sell them firms sell their future products in advance in this case in this sense these commodity markets are effectively functioning as derivative markets are markets for derivatives and for that exact reason they are they can work quite well for our purposes so they function pretty similarly to financial markets now what are the questions that we would like to ask in relation to financial markets recall that our most fundamental question was how can we ensure efficiency in these markets how can we ensure that they are working properly in order to answer that global question we will of course look at different parts of the markets and see how these different parts function in particular our very important interesting question is how are market prices created the classical economic theory for the most part tells you that market prices are set by the invisible hand of the market in economics 101 in your introduction to economics you have seen demand curve the supply curve and the point at which they intersect gives you the equilibrium and this equilibrium is characterized by some volume of trade and some equilibrium price but how exactly does the market arrive to this price is the question in this course we will look at some of these foundations we&#39;ll see how at the microstructure of markets so we will see who names the price and how do they do it in particular we will see how the prices are affected by traders behavior and the environment that they have to operate in importantly we will see how traders act on their information namely if i have some advantageous informations compared to the market how exactly should i trade upon this information given that everyone else in the market is not stupid they would expect me to trade on this information so i want to fool them into thinking that i am uninformed so this may sound a little cryptic currently but you will see a little later what i mean now these first micro questions micro foundation microstructure questions will allow us to take this analysis and see how exactly we should organize the market so we will see whether market rules matter or in particular which aspects of market design matter and which do not and if market rules matter for anyone we will see some theories which will allow us to conclude whom exactly do these the do these rules better do these rules benefit and whom do they hurt in order to make a conclusion about whether market is functioning efficiently or not and whether any kind of policy helps the market or hurts it we would need some measure of efficiency so the the definition i gave you was pretty much binary right the market allocation is either efficient or not but as we all know only the safe deal in absolutes so we need some relative measures to compare two imperfect situations and to see how more how much more or less imperfect is one situation as compared to another so how do we measure if markets are working well we will be looking at a few measures but the core concept that we&#39;ll be looking at throughout is market liquidity our next lecture will be devoted to defining market liquidity figuring out what exactly it is and how to measure it but this is the core concept that will be that will serve as our measure of how well the markets work a few closely related concepts are market depth trading volume in the market efficiency even though we have already defined it we can look at market efficiency in a lot of different ways and we will see what are the possible dimensions of efficiency and finally we will talk a little bit about market stability how well can it react in response to shocks so broadly speaking this is the split at least the textbook part [Music] across the dimensions above not really the dimensions above but so we will answer these questions using different methods different approaches today and in some of the other uh actually in a lot of other lectures we will talk about the institutional details policy issues and applications so we will basically speak about how markets actually work in the real world so you&#39;ll see those descriptions and some facts about real world markets what we will do using that knowledge is we will build theories to understand and to analyze policy within the frame of those real-life institutions and possibly beyond if we want to analyze some possible changes to real-life markets finally while not the primary focus of this course we will also look at some empirical issues that arise when you want to take the theories that we develop in this course and take the concepts that we introduce and want to apply them to data or want to estimate them using the real-life data given that real-life data is quite often not ideal some challenges will be in order but we will bravely face them and we will overcome now this to remind you is a university master&#39;s level course and as such you can expect that there will be some prerequisites some things that you need to know before you actually um delve through this course in particular i expect you to know some basic finance i wanted to know what stocks are what bonds are what discounting is how can you compute the expected value of a given asset on a very basic level so i want you to not be completely lost in the financial terms that we will be using secondly we will be using a lot of tools from basic microeconomics in particular game theory there will not be anything too difficult or deep in that dimension but you need to know what a nash equilibrium is and you would want to know some you would want to be familiar with some of its extensions for example sub game perfect nash equilibrium for the case of sequential move games or bayes nash equilibrium for the case of incomplete information games or perfect base in equilibrium for the combination of the two once again you do not need to have a deep knowledge of game theory but you need to at least have heard about it at some point finally some knowledge of math is in order in particular you need to know some basic calculus optimization theory and probability theory again all of this is needed on a very basic level for example from probability theory the two things you need are base rule and how to compute a mathematical expectation of a random variable from optimization theory all you need is knowledge of how to find a maximum of a smooth function on a compact interval so no particularly esoteric topics will be used but some background is required finally just a point of order is that this course explicitly focus on rational models where we constrain our economic agents in our models to behave rationally in the economic sense of view there is a complementary field of behavioral finance which you may also be which you may also explore if you are interested in in finance in general because as i said behavioral finance provides a very complimentary point of view on some of the related issues on some of the same issues even this concludes the introduction and now let us well continue with the introduction right this was a very broad overview of how the course will work and now let us go a little uh closer to details and explore some of the core concepts that we will be using throughout this course we will begin with prices price theory is something that is very fundamental to economics again in the introduction to economics one of the first things that you one of the first concepts that you saw was market price and in those models we usually think there is one price at which trades happen in a given market and in particular there is no arbitrage meaning that no given agent has access to two different markets which have different price for the same asset so the agent can buy asset on one platform and sell it on another platform now this is neither of this is quite true in the real world firstly the law of one price does not hold exactly if one given asset be it a financial asset or really any given item if any given item is traded on more than one platform it will likely be traded at different prices slightly different but different nonetheless and this obviously enables arbitrage but the difference in these prices is made such that is usually such that such arbitrage is unprofitable however there is another dimension in which law of one price is violated in financial markets in particular in particular in even if we focus our attention to any single financial market you will have more often than not not one but two prices in that market you will have a bid and an ask price a bid price would be the price at which you can sell your asset to the market and an ask price would be the price at which you can buy the asset from the market and it will typically be the case that an ask price will be above the bid price so that if you want to buy the asset and then immediately sell it the profit from such a round trip would be negative so this is a requirement of no arbitrage condition and within any given market such arbitrage typically holds now the difference between the bid and the ask price is called the bid ask spread and a lot of this course is devoted to analyzing how exactly this spread is determined and what drives it why are we so interested in this spread well the answer is simple if there is such a price at which you can neither buy nor sell the asset the market outcomes are likely to be inefficient because if you have such a if you have a valuation for an item which is between the bid and ask and there is another agent whose valuation for the item is also between the bid and ask so inside the spread and the two of your valuations is are different there can be scope for profitable trade between you and that agent but due to prices being [Music] due to your evaluations being inside the spread neither of you can neither buy nor sell to one another at a mutually acceptable price so the existence of the spread is a impediment to market efficiency the existence of the spread is a friction that our market faces so we will our investigation of market efficiency is actually intimately connected to the investigation of the bid ask spread and even if you have never traded in financial markets if you have never seen financial market quotes chances are you have encountered bdesk spread in real life if you have ever traveled abroad and you had to buy or sell foreign currency you know that the prices which you can buy the currency are very different from the price at which you can sell this currency and those are typically there is quite a significant wedge between the two the idea here is very similar this however is an example of how uh stock market quote can look like so this is a information sheet for google stocks from january of 2015. i of course i could update it for 2020 data but it&#39;s not that much different so even here you can see that even though there is one outlined price 518 dollars and four cents per stock the actual prices are quite different the actual prices at which you can trade are different in particular the market bid is 5 18 and 80 cents and this is the price at which you will be able to sell any extra google stocks you might have while the ask price is 520.95 so if you want to buy stocks you will have to buy at this price and you see that there is a wish between the two in this particular case both the bid and the ask are above this outline price and this can be connected to the fact that this outline price is quite often the price of the last trade so this is the backward looking price while the bid and they ask are forward-looking prices these are prices at which you can trade in the future and in this particular case the divergence between the two can be driven by the fact that some information got revealed in the interim which led to everyone agreeing that google stocks are worth more than 580 dollars and four cents there&#39;s a lot of other data you can see in this information sheet you can see the volumes of trade in a given day you can see some ranges that prices have taken in the past day or a year to estimate the volatility of the price so let us go back to one of the fundamental questions we asked that price of the google stock the 518 dollars and four cents where did it come from who decided that the google stock was worth 518 dollars and four cents today in general the asset pricing theory tells us that this so to say fundamental value of the stock the actual amount that it&#39;s worth if you can even objectively define it comes from the stream of future incomes that the stock can give you so either dividends or price appreciations and these future incomes are driven by a lot of different factors a lot of different managerial decisions within google so they&#39;ll be driven by how much research and development google does how well it is governed how well its marketing department works what is the competitive environment that it faces and many many many many more so you can argue about the fundamental value of the stock given the combination of these factors all day long you can argue about how these factors aggregate into a single value for a very long time what we will do in this course is not this so we will not discuss how exactly to determine this fundamental value what we will do instead is we will take the fundamental values given and we will analyze how this fundamental value translates into the market prices so we will ask whether market prices reflect this fundamental value accurately or there are any systematic deviations in particular the concept one of the concepts that we will look at is price discovery and this has to deal with how how much information about the fundamental value can be extracted from market prices or conversely how quickly does any new information about the fundamental value get incorporated into the market prices now so far in your previous economics courses you have been used to analyzing some abstract long run equilibrium allocations and prices right so you assume that there was some market demand market supply which are all likely composed of a lot of different agents and you said that well if these agents interact with each other which they will probably do in a long enough perspective then market will [Music] the market will settle down on some given price and after all trades are said and done a given allegation will establish well in this particular course we once again we zoom in on that interaction we ask how exactly those prices and allocations are established and the important step in this analysis is understanding that not everyone who wants to trade in a given asset is present in the market at the same time so going back to our google document spreadsheet daily trading volume was about 2 million stocks 2 million times 500 gives us about 1 billion dollar in daily trade in google stocks and if we have if we sum up those volumes over month or a year you will get well proportionally more but is it true that we can analyze all of the agents who trade google stock across a year and we can pull them together in this econ 101 analysis can we aggregate them all in single market demand curve and market supply curve probably not because if i want to trade a stock today it is not guaranteed that i will still be willing to trade in this given stock tomorrow so there is a given disconnect in times at which the agents trade and if we take the slice of the market for any given time period we will see that there is no longer a huge infinity of agents on either side of the market but actually there are only a few agents again on either side of the market only a couple of agents willing to buy a few more willing to sell or vice versa and so these agents are interacting with each other but they are not directly interacting with all of the other people who want to buy or sell billion dollars worth in google stock in particular this kind of limitation limited capacity of both supply and demand in the market at any given time can lead to temporary imbalances so we can not really guarantee that the supply of the asset at any given time will equal the market demand at the same time so you can have the situation in which you have too many sellers at some point in time which will result in the fact that price in that short time period will be lower so if a lot of people want to sell today they will compete with each other driving the price down which will mean that a market price becomes lower but once this imbalance is eliminated once all of these sellers got to sell or once more buyers arrive the prices do return back to their you can say long run level so given that we asked a lot of questions about the price uh how it translates how well it reflects the fundamental value and how quickly does it incorporate any information about the fundamental value we need to analyze all of these market imbalances another manifestation of this limited capacity of the market is that it is it might be quite costly to execute large orders quickly so if you are the only seller of a given stock in a given time frame you only face a limited number of potential buyers so if you want to sell a lot and you try to sell this huge amount within the short time frame then you&#39;ll probably have to agree to a low price once again if there is a too much supply this drives the price down however if you if your trade is not urgent so if you want to sell a lot of the asset but you do not need to do it now you can wait a few seconds a minute an hour then you can spread your trade over this time frame which will not create as heavy an imbalance and which will have less of an adverse effect on prices so if you&#39;re willing to spread your trading time you will get a more favorable price on average all of these effects are related to the liquidity of the asset which is the concept that i&#39;ve already mentioned liquidity is slightly again abstract concept according to wikipedia market liquidity is the market&#39;s ability to facilitate an asset being sold quickly without having to reduce its price very much and slightly vague definition but you can see what it means so if you are the only seller in the market and you want to sell a lot and you want to sell it now then basically liquidity can on a very surface level tell you how much of a discount will you have to take in terms of the price as compared to the fundamental value so if you will have to sell very cheaply it means that the market is not very liquid right now or vice versa if the market is very liquid at any given point in time means there are a lot of buyers in the market and a lot of sellers in the market at any given time which means that any order you throw at the market will be absorbed by the market without any heavy effect on the price so for example if you want to sell a google stock the market for those is pretty liquid once again 1 billion daily trading volume but if you want to sell a stock for a small danish company you will likely have a harder time doing that because there are not so many traders willing to buy those at any given point in time once again in the next lecture we will develop some measures of liquidity and we will talk about what exactly is liquidity and how to measure it and a lot further on in the course we will argue that sometimes more liquid assets may be more valuable so not only is liquidity measuring how far does the price deviate from the fundamentals in response to trades but also the feedback might go the other way around and liquidity may itself be a factor in the fundamental value of the asset now market depth is a closely related concept and the distinction between depth and liquidity is very subtle in particular you can consider market depth as one of the aspects of market liquidity so market depth in particular measures how big of an order is required to change the price of an asset by a fixed amount so liquidity in general can measure how much of a discount uh respective to the fundamental value will you have to take uh for your trade in order to sell the asset and there are a lot of ways in which you can measure that market depth is more precise it shows you how exactly does this discount change with the order size so in principle you can see market depth as a first derivative of market liquidity with respect to the order size why do we care about market depth well for all the same reasons that we care about market liquidity in general observing market depth may be a little more difficult than observing liquidity because even though previous trading prices are quite often observed and you can observe the best quote on either side of the market at any given point in time but it is sometimes harder to know what will be the quotes beyond this best one so these quotes are only valid for a specific amount of stocks and if you want to buy or sell more than this amount you will have to go deeper into the market and there is no knowing which price is that height so these are some of the core concepts that we will be talking about uh in this course once again we will be returning to most of them and we will be defining them more precisely later in the course for now however let us also talk a little bit about the institutions in the financial markets so how exactly are these markets organized and once again we will be primarily talking about the secondary market now you can very roughly split financial markets into two categories according to how trade is organized in this market on the one hand you will have order driven markets where orders are submitted into a common limit order book and there is some person or algorithm matching these orders and they execute against one another so if you&#39;re willing to buy the asset then you your order is matched with that of some trader who is willing to sell the asset on the other hand you have dealer markets where all trades happen through a centralized intermediary so when you want to buy or sell you do not necessarily deal directly with another trader on the other side of the market but you are rather dealing with the market appointed dealer or the market maker and this dealer is obliged to buy or sell any given amount at a given at some prices and this dealer sets prices over time so as to manage their inventory and their profits of course so looking at both of these categories in more details let us start with order driven markets and you can well very roughly see these markets in as a two-stage process so first orders are submitted then trades are arranged given these orders now the frequency at which these two stages are repeated can vary in particular you can have continuous markets in which effectively this loop occurs in at any given point in time so in continuous markets orders are persistent meaning that once you submitted the order to the market it is uh it stays there in the limit order book until it is executed or until you cancel it a converse to continuous auctions continuous markets is given by the call auctions in which this loop occurs with a given frequency which is not infinite so there can be a given time frame such as a minute an hour or something on other magnitudes and first of all orders are submitted during this time interval but no trade is taking place during this time interval and once the period ends the trades are arranged given all of the orders that were submitted during the time period so these are call auctions another dimension in which order driven markets can differ from one another is in terms of the order precedence so if there are many markets if there are so many orders on any given side of the market which is probably the case unless the market is very illiquid if there are many orders which is the order in which they are executed no pun intended so if there are many people willing to buy who gets to buy first whenever a seller arrives quite typical and i would dare say first order priority is the price priority so among all buyers the one who gets to buy is the one who offers the highest price is the one who offers to pay the most for this product but then what happens if two different buyers are willing to pay the same and this same amount is the highest amount in the market how do you split between these two buyers how do you break the tie well second order priorities can vary from market to market and one option is time priority meaning that if two traders are willing to pay the same amount for the asset the one who submitted their order first is also the first to execute first in first out another dimension of uh order precedence that can be relevant is the visibility of the orders in particular limitary books are often organized or sometimes organized in such a way that you can choose whether your order is visible to other traders when they submit their order or if your order is hidden so it is not shown in the limit order book but whenever a profitable a a profitable trade can be arranged your order is still counted whenever such an opportunity exists it is typically the case that visible orders are executed again sorry are executed before the hidden orders so visible orders have the priority again for a given price moving on another dimension in which or driven markets can differ from one another is the price interval in particular when the trades are crossed when the trades are arranged given a given a given set of orders do do you cross them and set the one price which fits everyone so like in the intro to econ you have this market price after you cross the demand and supply and you force everyone to trade at this same price or do you allow for discriminatory pricing in which different trades can happen at different prices beyond that there can be some heterogeneity in whether price is directly determined from the orders or if the price is taken from for example some other exchange which is sometimes the case when the asset is traded on more than one exchange finally markets are very heterogeneous in terms of what happens at the beginning at the end of the trading day for example even if uh trade is organized via continuous trading during the day it might still be the case that during the first 15 minutes no trade takes place and there is some call auction happening the pre-trade so to say and such pre-trade auction happens in many markets sometimes the same happens at the closing of the market in which 15 or 30 minutes before the market is closed all trading stops and all orders are accumulated into one limitary book and then at the closing times all of these orders are crossed with one another so opening closing hours quite often have some special trading rules and these rules may be different across different exchanges now when talking about market orders that can go into the limit order book there can be different kinds of orders that we can talk about for the most part we will be talking about two namely limit orders and market orders and for this discussion i would like to think about a continuous market in which trades are cleared whenever there is an opportunity for profitable trade to be cleared in such a market a limit order would specify a quantity and a price meaning that a limit order would say something like i would like to buy 500 shares at a price of no higher than 40. in your order a limit order like this would be submitted to a limit or a book and it would stay in the book once again until someone would be willing to sell you these 500 shares at a suitable price or until you cancel it these limit orders are quite often cross against market orders a market order specifies the quantity and it says i would like to buy or sell this quantity immediately at the best available price so if you have submitted a limit or saying that you would like to buy 500 shares at a price no higher than 40 then it can be executed if either someone submits a sell limit order saying that they would like to sell 500 shares at uh some price which is lower than 40. or if we market if a market sell order comes meaning that some trader would say i would like to sell 500 orders at the best available price and so if your limit order features the best available price this is the match that will happen so market orders are executed immediately at the best available price while limiter books limitor sorry limit orders stay in limitary books until a suitable trading opportunity arrives now we when we will be talking about such order driven markets we will discuss what kinds of traders decide to use which orders and one thing that we will discover for example is that patient traders are usually more passive in that they use limit orders they are willing to wait in exchange for getting a better price on their trade and we will say about limitors that they provide liquidity to the market they give these trading opportunities to other traders at the same time the impatient traders are more aggressive they use marketers because they want their trade to be executed now because they are impatient so they take liquidity from the market they deplete the limit order book using their market orders and so we have already talked about uniform versus discriminatory pricing but to emphasize this again generally the pricing is discriminatory in at least some sense in particular the price that you will get will almost often depend on when exactly you decide to trade because this will define whom you are trading against what is the state of the market at that given time so there is always some degree of discrimination now when we talk about two different markets two different orders that were submitted at the same time to the same market whether these would be executed at the same price at the uniform price or their individual discriminatory prices this can vary from market to market now some examples of continuous limit or book exchanges are new york stock exchange so one of the largest stock exchanges in the world it&#39;s either the top 1 or top 2 with nasdaq as its partner and new york stock exchange has both electronic and outcry markets it is one of the very few remaining exchanges who that still has open outcry market i am not fully confident that it is still there but i believe that outcry market was in place as re as recently as five or ten years ago in europe continuous or given markets are given by london stock exchange or bats in my belief barcelona or euro next which has many different venues all across europe so this is a continuous limiter book trading is a very popular way of organizing markets now moving on to call auctions these are auctions in which as i said trade happens at a given frequency so first orders are collected in some batch and after a certain number of hours are collected over a fixed time period they are all cleared simultaneously now the price of such a trade is chosen such that to maximize the number of executed orders given the order submitted to the limitary book notably in this case you will have uniform pricing so all orders in the batch will trade at the same price be those orders to buy or to sell the asset now as i said this uniformity only applies to the trades within the given time frame but if you trade in different periods you will still face different markets different limiter books and probably discriminatory prices so in theory this uniform pricing gives us some very good efficiency properties right because we discussed that inefficiencies arise because the price of the asset deviates from its fund from the fundamental value of that asset and prices deviate from uh for buy and sell orders use the b desk spread so it seems like in the presence of uniform pricing there is no spread so all trade trading should be efficient but there are some drawbacks to call auctions as well in particular the trivial one is that trades happen slower than in the continuous market so some impatient traders may not be willing to trade in call auctions which can have various long-running repercussions such as lower trading volume on aggregate other traders not willing to trade because trade volume is too low and the market is too liquid and so on and so on so absence of impatient traders can have long running repercussions now examples of call auction exchanges are a lot of major exchanges nasdaq is one now lse also has and euronext also have call auction exchanges in addition to continuous trading which may operate in parallel for some assets so most of these exchanges operate call auctions together with one of the other trading methods meaning that in parallel with either continuous trading or in parallel with the dealer i&#39;ve already mentioned the main distinction but to reiterate once again in order driven markets the idea is that traders are matched directly with one another so you can buy the asset only if someone else is willing to sell the assets at the very same time in dealer markets the situation is different in particular there exists the central intermediary the market maker the dealer who is tasked with buying the asset from whoever is willing to buy and from selling the asset to whoever is willing to sell and the dealer can set the prices so as to approximately equalize the demand and supply so the dealer quotes a bid and ask price which are typically valid only up to certain number of shares and if you want to trade a lot if you want to trade large amounts against the dealer you would likely have to negotiate with them individually regarding the price that they can offer you now this dealer will likely quote the positive bid ask spread so the dealer will not be willing to buy and sell at the same time at any given at the single price because they need to eat they need to generate some trading profits in order to make all of this worth it but at the same time if the dealer makes this bds spread too wide then some of some competing dealers can attract all business to themselves so if dealers are competitive they will have incentives to make their bid ask spread narrow enough to attract some given trade but while still generating some trading profits necessary for subsistence so a reasonable question to ask here is how competitive would the prices be in any given organization of the market in any given mode of interaction between the dealers or between the traders and the dealers now dealers profits are not are needed not only because dealers are such self-centered profit maximizing entities but simply because they have some costs in their operations so firstly they need to incur some transaction and operation cost they will be subject to inventory costs because they will likely end up with some positions in the asset they will end up either having some positive stock of the asset or owing some positive amount of the asset and if the price of the asset changes while the dealer has this position it may give it may result in a call in a loss for the dealer it may also result in a profit but it rarely will finally the dealers will also have to deal with the adverse election so dealers will have to deal with having to trade against more informed counterparties the main example of a dealer exchange is nasdaq as i said either top one or top two stock exchange in the world by trading volume so you can say the dealer exchanges are also quite quite prominent now moving on from the distinction between order driven markets and dealer oriented markets you can also vary you can also class classify markets according to how they are organized and how strongly they are regulated the most formal and regulated markets are exchanges so stock exchanges first and foremost or other kinds of exchanges and these are organized exchange venues so new york stock exchange nasdaq london stock exchange are all in this category and they typically not only offer a place and a time to trade but they offer a lot of side services so we mentioned that one purpose of the market existence is providing security to the trades and this is one of the services that these exchanges provide so they [Music] typically provide clearing and settlement services ensuring that you pay for what you bought and you get the item that you actually bought an indirect service provided by these exchanges is liquidity and stability so exchanges are interested in markets functioning smoothly because it allows them to attract the business so these mark these exchanges will by themselves uh employ specialists or market makers in order to provide liquidity in the market and to stabilize the particularly sharp market fluctuations and finally we have also discussed that uh exchanges yield in some degree of transparency so they make past trades observable they make quotes more easily available to potentially interested traders so transparency is one of the perks that exchanges bring through their existence now a counterpart to exchange trading is over-the-counter trading or otc trading and broadly speaking uh you can classify otc trading as everything that is not traded through the exchanges so if we meet in a dark alley um and i sell you a stock this would be an example of over-the-counter trading so these are off-exchange venues in current days otc venues are quite often also very formalized and very organized platforms so they differ from exchanges in a very slight and subtle ways mostly in terms of the requirement for company transparency for the transparency of companies financial reports so otc platforms uh the decentralized ones do not require firms to make so much financial disclosure as the big exchanges but of course this perk for the firms comes with corresponding benefits namely that traders will likely not be willing to trade in such non-transparent stocks otc platforms may vary in their liquidity provisions so they may have less incentives to provide liquidity but in the big picture in the big scheme of things they are still quite similar to the exchanges so the distinction may be quite arbitrary and subtle finally one thing to point out here uh is dark pools of liquidity so these may or may not belong to otc platforms depending on the classification you use but dark pools of liquidity are usually classified as some internal platforms for example a large investment bank can match the orders of its clients against each other instead of forwarding these orders to the exchange and such dark pools of liquidity have risen quite prominently in the recent years in the recent 10 20 years and they have been one of the subjects of recent financial regulation in both u.s and the european union so we will talk about those a little more when we talk about market transparency so this was the classification or two different classifications of different financial markets and we saw that markets can generally differ in a lot of different dimensions so what should we look at when we want to compare these markets what are the factors that we would that we would want to focus upon and this of course all depends on whose perspective you want to take if we see us as a regulator who wants to devise the rules for these exchanges to operate then you would like to ensure competition on all sides of the market because it typically results in efficient allocation but typically efficiency would be the part that you would be most interested in all the various ways in which the factors that we mentioned the degrees of heterogeneity that we mentioned affect liquidity effect efficiency i&#39;m sorry on the other hand if you take the perspective of the trader then you don&#39;t really care about efficiency right you don&#39;t really care whether the assets are allocated efficiently in the end whether you get to sell your asset to whoever values it the most but rather you would care about selling your asset at the highest value you would want to get the best bang for your buck or in this part in in case you are selling the asset it will be the opposite right the best buck for your bank so if you are a trader you would care about liquidity in the market because liquidity basically determines how big of a discount you need to take when you are selling the asset you would care about the transparency in the market because transparency determines how well you can actually determine how much your asset is worth and how much you can sell it for relatedly you would care about the information available in the market but in this case not the information you can directly observe but rather about the information that you can infer from for example market quotes so you see that different agents in the market care about different different aspects different dimensions different measures of market operation and we will look at all of those when we get to analyze the models but to take a second to explore in slightly more detail the agents that we have in the market the most we will put the most focus on the three following groups of the agents first we will be talking about traders or investors who will be the in essence the end consumers the final consumers or suppliers of the asset so these are economic agents who want to hold the asset who want to assume some position in the asset beat long or short position we can classify these traders in in different dimensions so firstly [Music] from the background point of view you can distinguish retail investors and institutional investors retail investors are individual people who basically have an excess of savings and they would like to invest their money in the stock market institutional investors on the other hand are companies who have some funds wherever they may be from and they need to once again invest these funds into stock market an exam the examples of such institutional investors can be pension funds who need to manage people&#39;s savings or these can be mutual funds who collect money from the people who are not willing to invest in stock market directly who do not want to buy the stocks but rather they invest in the mutual fund which manages uh the portfolios and the mutual funds then invest these money on the people&#39;s behalf finally you can think of some private equity funds or all the various other kinds of for-profit traders so the distinguishing feature between these two categories is that retail investors are well let&#39;s say amateurs investment while institutional investors are usually professionals so these are people who get paid for devising the optimal trading strategies another dimension of heterogeneity in the investors that we&#39;ll quite often be talking about is informed versus the uninformed investors in particular we will be talking about whether the trader is trading based upon some private information that they have about the value of the asset and this private information is not available to the rest of the market excuse me or are these traders completely uninformed and they have the same information about the mark about the asset value as the market does and they trade for a variety of other reasons so they are trading not because the mar the tr the let me say that again they are trading not because the asset is mispriced compared to their perceptions but rather because they have a particular idiosyncratic need to trade in that asset so going back to our example if you work in coal industry you want to buy um a stock of renewable energy companies not because you have some difference of opinions compared to the market as to how much profit will this get you but rather you buy this in order to balance your portfolio so you have this idiosyncratic need to buy stocks of renewable energy companies and you do not necessarily have any informational advantage over the market often we will equalize retail investors to uninformed and institutional investors to informed but there is significant special case namely the pension funds who are institutional investors but are typically perceived as being uninformed investors so they do not have huge research departments saying where they should invest in but they have [Music] a lot of funds that they need to manage so this was an overview of traders or investors and there will be two different categories of intermediaries that we&#39;ll talk about we have already discussed dealers or market makers who are the intermediaries who are basically matching orders of different traders and supplying liquid to the market when there is none so dealers and market makers are the agents who are willing to buy or sell the asset when nobody else is and the third third category of market players that we will look at are the brokers so the brokers stand between traders and the investors if you think of the trading floor right so the old school stock exchange where there are a lot of people in suits shouting at each other then you will have a dealer in the center and brokers would be trading with the dealer you as a retail investor as a regular person you would not have access to the dealer because the dealer is a busy person standing right in there right there in the trading floor so what you would want to do if you needed to trade would be to call your broker for example an investment bank and tell your broker what is the trade that you&#39;re willing to execute and then the broker would relate that order to the market now we will very briefly touch upon different agency problems and conflicts of interest between traders and the brokers but we will not explore this conflict in great detail regulation so we have seen what markets can be what we should care about what are the players in the market how can we as regulators affect these markets and change market outcomes well first of all what are our goals the goals are pretty simple right we want to arrive at efficient allocation but if you want to split it into more micro goals then it will be potential protection against insider traders on the one hand so you would want to protect the uninformed traders against being picked off by those who are more sophisticated than them by those who have informational advantage over them but at the same time you want to keep the information flow running you want prices to be efficient meaning that you want to enable price discovery but price discovery is impossible without the informed traders so price discovery is only possible if informed traders are willing to trade and thus contribute their information to the market so you want to trade off these two aspects protection of uninformed investors and price discovery in the market another goal is stabilizing the market so in case of large sudden shocks or halts or short sale bands you want to smooth down the drastic uh drastic the periods of drastic volatility in the market and once again in order to ensure the agents one another in order to insure the agents yeah from these satin shocks since most economic agents are risk averse to one degree or another this would make the agents more willing to trade and would improve liquidity would improve efficiency and so on conversely speaking if agents expect that there can be large shocks in the market they would be more reluctant to trade which would be an impediment to efficiency so that is why you would want to stabilize these [Music] periods of large volatility and more generally you want to select the optimal trading structure on any given market so for assets the underlying financial assets are in themselves very heterogeneous some are some have large markets so a lot of people willing to buy or sell some of them have thin markets and you want to select the optimal trading structure for all of those uh assets popular and not volatile and not i guess these are two main dimensions in which assets can be heterogeneous how can you achieve these goals what methods do you have well some examples are we have already seen a lot of those right we have seen what are dimensions of heterogeneity of the markets and u.s regulator can quite often have control over these degrees of heterogeneity but to be more particular you can require of you require routing force between markets so if markets are fragmented if the same asset is traded on many different exchanges then you can require some degree of interaction between these markets require as in legally or you can impose some transaction taxes or subsidies you can impose some margin requirements so to require some certain degree of collateral in order to ensure the agents and to ensure the platforms against counterparty risk once again to make the trading less risky for everyone who trades with a given agent finally you can impose various policies on algorithmic and high frequency trading high frequency trading not high frequent trading because these again affect the market in non-trivial dimensions finally you would want to regulate the competition between exchanges between platforms because here the trade-off is once again non-trivial typically liquidity begins liquidity so i want to trade on the platform where everyone else is already trading because then i have more opportunities to trade this may stimulate the natural monopoly so it is more efficient to have one large market than the few small markets because such kind of fragmentation goes against all the goals of the markets in general that we&#39;ve seen however at the same time competition between platforms can improve the terms of trade that are offered to the traders so if you have one monopoly exchange that it would likely charge high transaction fees while if two smaller platforms compete with one another they would drive each other&#39;s transaction fees way lower the monopoly level so this is an open question on how much competition should we require among amount exchanges should require order routing which has its own perverse effects on competition should regulators require price transparency so to reduce the informational advantages that any given exchange has should we foster competitive market making all of these are open questions that we&#39;ll touch upon these are some statistics on real world exchanges and i believe these might be quite old again from maybe five years ago 2015 or so so these are stock exchanges by volumes of trade in billions of us dollars as i promised you new york stock exchange and nasdaq are the two largest exchanges by far so they are about four or three and a half times bigger than the next biggest exchange which is the japan exchange group but overall there are quite a lot of exchanges all over the world this graph i believe does not feature any more u.s exchanges but there are a lot of asian and european exchanges in here so the u.s exchanges are pretty concentrated there are two while european and asian are slightly less solvent it is an open question for us as regulators which is the better structure which is the better market structure which results in better market outcomes so this is the point that we should i would like to finish today as exercises for the next class you can begin by feeling a little immersed into the world of finance and find share prices bid and ask prices for some of the popular stocks such as facebook or microsoft a more interesting challenge would be to see which stock exchanges do these prices come from and you can figure out which stock exchanges are these shares traded on i will give you a hint there are many such exchanges secondly you can read the article about the london metal exchange which is one of the last trading floors the physical trading floors in the world and i believe the last physical trading floor in europe and the open question for this article is what is the value of keeping the this open outcry trading floor in the age of digital trading what is the value we have in this physical presence rather than moving this train digital as a reminder the link to this article is in the course files there is a list with links to all the articles finally if you have the textbook i invite you to solve exercises from 1 to 3 for chapter 1. and these deal with this give you basically an example of continuous and call auction markets and they give you a certain orders and you can compare market outcomes in case of continuous trading versus the call auction with that i sign off for today and we&#39;ll see you in lecture two you

Transcript for:Financial Markets Microstructure - Lecture 1

Transcript for:
Financial Markets Microstructure - Lecture 1