Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance

Market Structure, Trading, and Liquidity Slide 1

MBA 8750 – Current Topics SeminarThe Current State and Structure of U.S.

Financial Markets: Implications from the 2010 “Flash Crash”

Dr. Michael Pagano, CFAThe Robert J. and Mary Ellen Darretta

Endowed Chair in FinanceProfessor of Finance

Villanova School of Business

May 12, 2011


Overview of SeminarAgenda Item Presenter Time

Welcome & Introduction to the Seminar Mike Pagano 6:00-6:05

The “Flash Crash” and what it means for you and your firm

Mike Pagano 6:05-6:30

Open Outcry Trading Exercise All 6:30-6:50

The Role of Options in Investing and Markets Lou DePaul 6:50-8:00

How Trading Firms can add value for Investors Mike Pagano and All 8:00-8:45

Wrap-up and Post-Work Mike Pagano 8:45-9:00

Market Structure, Trading, and Liquidity3

Is trading this simple? …


or slightly more difficult ??


What Motivates Trading?

1. New information (unexpected news)

2. Liquidity needs

3. Divergent expectations (people agree to disagree)

4. Technical (noise) trading


Fundamental Financing ChannelsFirm Investor

Firm InvestorIB / CB

Buyer Seller

Agent

Exchange

or Market Maker

Agent


The Equity Markets

U.S. Equity Market Centers National Markets: NYSE, Nasdaq, BATS, DirectEdge

Regional Exchanges: Boston, Chicago, National, Pacific, and Philadelphia

Over-the-Counter Market (OTC) Alternative Markets (ATSs, ECNs, “Dark Pools”), e.g.:

– INET (ECN part of Nasdaq now)– Arca (part of NYSE Euronext now) – POSIT (Investment Technology Group)– Liquidnet and Pipeline (private block trading networks)– Sell-side Dark Pools run by Goldman, Credit Suisse, etc.


Trading Players

• Retail Investors• Institutional Investors• High Frequency Traders (HFTs)• Speculators• Dealers / Market Makers• Brokers• Exchanges• Off-Exchange Trading Systems• Corporate Issuers• Regulators


Major Trading Issues

• Liquidity

• Informative Prices

• Volatility

• Transaction Costs

• Trading Profits

• Net Investment Returns


The Iceberg of Transaction Costs

Source: Plexus Group, 2003

Commission 5 ¢ (17 bp)

ImpactImpact10 ¢ (34 bp)10 ¢ (34 bp)

Delay23 ¢ (77 bp)

Missed Trades9 ¢ (29 bp)


Trading Cost Components• Total Cost = Commission

+ Impact (intra-day) + Delay (inter-day)

approx. 157 bps (one-way)

314 bps (round-trip!)

• What is the cumulative impact on a 10% gross annual return over just 1 year?

• Answer: Net return is only 6.57% (a 34.2% decrease!)


10:50 10:55 11:00

PublicBuyer

PublicSeller

LimitOrder

Executes

Placesa BuyLimit

Order

Order Driven Market

The limit order book brings

buyer& seller together

The limit order book brings

buyer& seller together


BIDS PRICE OFFERS

11.30 91

11.25 0

11.20 52

11.15 24

11.10 7

11.05

11.00

35 10.95

70 10.90

0 10.85

20 10.80

67 10.75

39 10.70

46 10.65

The Limit Order Book

Bid – Ask Spread(10.95 - 11.10)

Air Pocket

Air Pocket

Market Structure, Trading, and Liquidity Slide 14$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Ask

Bid

P*

Day 1 Day 2

P* and Best Bid and Offer Quotes


Order Flow is “Fuel” For a Market

Order Flow = Liquidity

An excellent system will not operate if it does not receive

Critical Mass Order Flow“Order flow attracts order flow”


Liquidity

Main Attributes of a liquid asset Breadth: orders on the book exist at an array of

prices in the close neighborhood above and below the price at which shares are currently trading.

Depth: orders are of large size. Resiliency: price changes due to temporary order

imbalances quickly attract new orders to the market, thereby restoring reasonable share values.

Frequent trading (at high speed).


The Raison d’être of Algorithmic Trading

o Dynamic price discovery

o The fast speed in which events can occur

o Exploit Market inefficiencies to ↓ costs and ↑ profits


The 9/30/2010 CFTC - SEC “Flash Crash” Report


Flash Crash Summary of EventsThe events of May 6 can be separated into 5 phases (shown in Figures 1.1

and 1.2 on following slides):• Phase 1: From the market’s open through about 2:32 p.m., prices were

broadly declining across markets, with stock market index products sustaining losses of about 3%.

• Phase 2: From about 2:32 p.m. through about 2:41 p.m., the broad markets began to lose more ground, declining another 1-2%.

• Phase 3: Between 2:41 p.m. and 2:45:28 p.m., lasting only about four minutes or so, volume spiked upwards and the broad markets plummeted a further 5-6% to reach intra-day lows of 9-10%.

• Phase 4: From 2:45 p.m. to about 3:00 p.m., broad market indices recovered while at the same time many individual securities and ETFs experienced extreme price fluctuations and traded in a disorderly fashion at prices as low as one penny or as high as $100,000.

• Phase 5: At about 3:00 p.m., prices of most individual securities significantly recovered and trading resumed in a more orderly fashion.


More on the Flash Crash…

1. STOCK INDEX PRODUCTS: THE E-MINI FUTURES CONTRACT AND “SPY” EXCHANGE TRADED FUND (ETF)

2. A LOSS OF LIQUIDITY IN THE E-MINI AND “SPY” ETF MARKETS

3. AUTOMATED EXECUTION OF A LARGE SELL ORDER IN THE E-MINI FUTURES CONTRACT

4. CROSS-MARKET PROPAGATION (FUTURES TO CASH MARKETS)

5. LIQUIDITY IN THE INDIVIDUAL STOCKS THAT COMPRISE THE S&P 500 INDEX


Key Graphs from CFTC / SEC Flash Crash Report


Key Graphs from Joint Flash Crash Report (cont.)












Key Regulatory Topics

HFT and Market Stability (limit up/dn; breakers)

Reg NMS and Market Fragmentation

Level Playing Field: NYSE, Nasdaq, ECNs, ATS

Fairness for Retail vs. Institutional Investors

Insider Trading and Increased Surveillance

Mergers of For-Profit Exchanges / ATS firms

Impact on Corporate Issuers (e.g., WACC, prices)


Homework Assignment

Written deliverable (reflection paper on pre-work and in-class activities) to be graded by Prof. Pagano.

The assignment will be to discuss the concepts and experiences from this class that were most salient to your own personal investments and / or your firm’s situation.

Please limit your response to 350 to 500 words (i.e., 1-2 pages, double-spaced with 12 point font size).

Documents

Dr. Michael Pagano, CFA The Robert J. and Mary Ellen Darretta Endowed Chair in Finance