their clients.Standing orders are open offers to trade. Joe’s order will stand until someone sells to Joe at 100dollars or less, the order expires at the end of the day, or Joe cancels it. Standing orders are alsocalled open orders. Since standing orders allow other traders to trade when they want to trade,traders offer liquidity when they have orders outstanding.Traders who want to trade quickly demand liquidity. Traders take liquidity when they acceptoffers—standing limit orders or quotes—that other traders made. If Sue is willing to sell 100shares of IBM at 100 dollars, she can initiate a trade by taking Joe’s offer.Traders who demand to trade immediately demand immediacy. We show in Chapter 19(Liquidity) that immediacy is one of several dimensions of liquidity.A market is liquid when traders can trade without significant adverse effect on price. Marketswith many standing limit orders and small bid/ask spreads are usually quite liquid.The prices at which orders fill are trade prices. Buy orders that trade at high prices and sellorders that trade at low prices trade at inferior prices.Markets and traders sometimes treat orders differently depending on whether they are agencyorders or proprietary orders. Agency orders are orders that brokers represent as agents for theirclients. Proprietary orders are orders that traders represent for their own accounts. In manyorganized markets, agency orders have precedence over proprietary orders at the same price.
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Chapter 5Market StructuresThe trading rules and the trading systems used by a market define its market structure. Theydetermine who can trade; what they can trade; and when, where, and how they can trade. Theyalso determine what information traders can see about orders, quotations, and trades; when theycan see it; and who can see it.Market structure is extremely important because it determines what people can know and do in amarket. Since power comes from knowledge and the ability to act on it, market structure helpsdetermine power relations among various types of traders. These relationships greatly affectwho will trade profitably.To trade effectively, you need to know the structure of every market in which you trade. Thetrading strategies that are successful in one market often do not work well in markets withdifferent structures. The best order submission strategy for a given trading problem generallydepends on the structure of the market where the trader intends to solve the problem. Traderstherefore behave differently in different markets.You must understand market structure, and how it affects trader behavior, to understand theorigins of market liquidity, price efficiency, volatility, and trading profits. These variables alldepend on trader behavior. Since market structure affects trader behavior, it helps determinewhether markets will be liquid, whether prices will be informative, and which traders will tradeprofitably.We will introduce and describe a framework for classifying market structures. Thisclassification scheme will help you recognize how markets are similar and dissimilar to eachother. Being able to classify market structures will be useful to you since trading problems havesimilar solutions in similar markets. If you understand how to trade in one market, you shouldbe able to apply your knowledge and experience to other similar markets. We will use thisclassification system throughout the rest of this book.We will start by discussing the different types of trading sessions that exchanges, brokerages,and dealers organize. We then will discuss the various execution systems that traders use toarrange their trades. Finally, we will describe the information processing systems that transmitorders into and out of markets, present market information to traders and to the public, and storeopen orders.5.1 OverviewTrading takes place in trading sessions. The two types of trading sessions are continuous tradingsessions and call market sessions. In continuous trading, traders can attempt to arrange theirtrades whenever the market is open. In call markets, all trades take place only when the marketis called.Trading forums are the places where traders arrange their trades. In physically convenedmarkets, traders must be on a trading floor to negotiate their trades. Physically convened futuresmarkets trade in trading pits. Physically convened stock markets trade at posts. In distributed
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access markets, traders use telephones or screen-based trading systems to arrange their tradesfrom their offices.Physically Convened Screen-based MarketsAlthough screen-based trading systems are ideally suited for distributed access markets, manyAsian exchanges with screen-based trading systems once required their traders to be on theirtrading floors to use their electronic systems. This arrangement made it easier for exchanges toregulate their traders. It also allowed them to construct reliable communications networks,which was once an important issue in countries with poor telecommunications infrastructures.Many traders like to trade in physically convened markets because they enjoy the society ofother traders. Now that exchange regulations no longer require them to be there, many tradershave stayed on the exchange floor.Some countries require that traders arrange all trades in a given instrument at a particularexchange. For example, with few exceptions, it is illegal to arrange trades in a Chicago Board ofTrade corn futures contract outside of the corn futures trading pit on the CBOT floor. Theserestrictions are common in many futures markets and in the equities markets of some Asian andEastern European countries.Traders and exchanges use various execution systems to arrange trades. In quote-driven systems,dealers arrange most trades when they trade with their customers. In order-driven systems, alltrades are arranged by using order precedence rules to match buyers to sellers and trade pricingrules to determine the prices of the resulting trades. In brokered trading systems, brokersarrange trades by helping buyers and sellers find each other.Various information systems move information in and out of the market, present it, and store it.Order routing systems send orders from customers to brokers, from brokers to dealers, frombrokers to markets, and from markets to markets. These systems also send reports of filledorders back to customers. Order presentation systems present orders to traders so that they canact upon them. The systems may use screen-based, open-outcry, or hand-signaling technologies.Order books store open orders. Market data systems report trades and quotes to the public.In most markets, traders can only use prices that are an integer multiple of a specified minimumprice increment. The size of the increment, measured as a fraction of price, varies considerablyacross markets. In Chapter 11 (Order Anticipators), we show that the increment is an extremelyimportant determinant of market quality in many markets.Price ClusteringTraders do not use all possible prices equally. Instead, their usage clusters on round numbers. Inmarkets with fractional prices, they use whole numbers more often than halves, halves moreoften than odd quarters, quarters more often than odd eighths, and eighths more often than oddsixteenths. In markets with decimal prices, prices that are integer multiples of 1.00, 0.50, 0.25,0.20, 0.10, and 0.05 are likewise most common. The clustering of prices is most pronouncedwhen the minimum price increment is a small fraction of price, the market is highly volatile, andthe instrument is thinly traded.
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Clever traders often consider the clustering of limit order prices when they place limit orders.They frequently place their orders just above or just below a round number to take advantage ofthe fact that many other traders may place their prices at the round number.5.2 Trading SessionsMarkets have trading sessions during which trades are arranged. The two types of tradingsessions are continuous market sessions and call market sessions.5.2.1 Continuous MarketsIn continuous markets, traders may trade anytime while the market is open. Trading iscontinuous in the sense that traders may continuously attempt to arrange their trades. In practice,they usually trade only when a trader demands liquidity.Continuous trading markets are very common. Almost all major stock, bond, futures, options,and foreign exchange markets have continuous trading sessions.5.2.2 Call MarketsIn call markets, all traders trade at the same time when the market is called. The market may callall securities simultaneously, or it may call the securities one at a time, in a rotation. Marketsthat call in rotation may complete only one rotation per trading session, or as many rotations astheir trading hours permit. Markets that call in rotation were once very common. Now only inthe stock markets of a few small countries call in rotation.Many continuous order-driven exchanges open their trading sessions with call market auctionsand then switch over to continuous trading. These markets also use calls to restart their tradingafter a trading halt. Open-outcry futures exchanges, however, start continuous tradingimmediately when they open.Call markets are used as the exclusive market mechanism for many instruments. Mostgovernments sell their bonds, notes, and bills in call market auctions. Some stock markets alsouse calls to trade their least active securities. The Deutsche Börse and Euronext Paris Bourse areexamples of such markets.Call Market Betting at the Horse RacesUS horse racetracks offer pari-mutuel betting to their betting clients. In pari-mutuel betting,bettors receive a share of the total money bet on all horses—less a fixed percentage for the trackand the state—if their horse wins. Bettors can place their bets anytime until betting closes a fewmoments after the start of the race. The track totalizator system displays the projected winningsfor each bet while the betters place their bets.Pari-mutuel betting is a call market auction in which the totalizator simultaneously prices all betson a race. (The price of each bet is the amount bettors must bet to receive a dollar if their horsewins.) The call occurs when betting closes. Since the system only allows market orders, manytraders wait until the last moment to bet so that they can see what the prices will be.
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Chapter 6Order-driven MarketsOrder-driven markets use trading rules to arrange their trades. These markets include oralauctions, single price auctions, continuous electronic auctions, and crossing networks. You willlearn how these markets work, and how trading strategies depend on market structure.Order-driven markets are quite common. Almost all of the most important exchanges in theworld are order-driven markets. Most newly organized trading systems choose electronic orderdriven market structures.Despite the great variation in how order-driven markets operate, their trading rules are all quitesimilar. All order-driven markets use order precedence rules to match buyers to sellers andtrade pricing rules to price the resulting trades.Variations in trading rules distinguish order-driven markets from each other. The tradingstrategies that work best in one market may work poorly in markets with different rules. Traderstherefore need to know how trading rules affect optimal trading strategies.If you trade in order-driven markets, the principles introduced in this chapter will be ofimmediate and obvious value to you. These principles will also help you understand frontrunning and block trading strategies that we will consider in later chapters.The topics in this chapter should also interest you if you are interested in market structures.Most recent innovations in trading technologies involve order-driven market structures. Toevaluate new trading technologies, you must thoroughly understand how they work.We will first discuss how oral auctions work. In these order-driven markets, traders arrangetrades by negotiating on a trading floor. Since many readers may already be acquainted withthese markets, they provide us with a familiar context for introducing various trading rules. Wethen will turn our attention to rule-based order-matching systems. These systems include singleprice auctions, continuous order book auctions, and crossing networks.6.1 Oral AuctionsMany futures, options, and stock exchanges use continuous bilateral oral auctions to trade theircontracts and securities. The largest oral auction market is the US Government Long TreasuryBond futures market. This market, which the Chicago Board of Trade organizes, regularlyattracts 500 floor traders. It may be the most liquid market in the world. The smallest oralauctions may include only two traders.In an oral auction, traders arrange their trades face-to-face on an exchange trading floor. Sometraders cry out their bids and offers to attract other traders. Other traders listen for bids andoffers that they are willing to accept. Most traders do both. Trades occur when a buyer accepts aseller’s offer, or when a seller accepts a buyer’s bid. In the former case, the buyer will call out“take it” to accept the offer. In the latter case, the seller will call out “sold” to accept the bid.Buyers and sellers often take turns bidding and offering until they agree on a price and quantityto trade. Traders offer liquidity when they make bids or offers to trade. Traders take liquiditywhen they accept bids or offers.
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The traders must obey the market trading rules. These rules organize trading to ensure fairnessfor all traders and to provide for the efficient exchange of information necessary to arrangetrades. The trading rules also help protect brokerage customers from dishonest brokers.The first rule of an oral auction is the open-outcry rule. Traders must publicly express all bidsand offers so that all traders can act on them. This requirement ensures that all traders can fairlyparticipate in the market. In most oral auctions, any trader can accept another trader’s bid oroffer, even if they are not actively negotiating with that trader. The first trader to accept a bid oroffer generally gets to trade. The open-outcry rule also requires traders to express theiracceptances publicly so that all traders are aware of the trades that they arrange. Thisinformation helps traders evaluate market conditions. It also protects customers from dishonestbrokers who might try to arrange trades privately to benefit their friends instead of their clients.6.1.1 Order Precedence RulesThe order precedence rules of an oral auction determine who can bid or offer, and whose bidsand offers traders can accept. In oral auctions, the primary order precedence rule is always pricepriority. The secondary precedence rules depend on the market. Futures markets use timeprecedence. US stock exchanges use public order precedence and then time precedence.6.1.1.1 Price priorityThe price priority rule gives precedence to the traders who bid and offer the best prices. Traderscannot accept bids or offers at any inferior price. Buyers can accept only the lowest priced offersand sellers can accept only the highest priced bids.Price priority is a self-enforcing rule because honest traders naturally search for the best prices.Exchanges therefore do not have to adopt special procedures to enforce it. They keep the rule ontheir books so that they can prosecute dishonest brokers.Most oral auctions do not allow traders to bid below the best bid or offer above the best offer.Since only the best bid and offer interest traders, bids and offers behind the market only createconfusion and noise.Traders acquire price priority by bidding or offering prices that improve the current best bid oroffer. Any trader may improve the best bid or offer at any time.6.1.1.2 Time PrecedenceThe time precedence rule used in most oral auctions gives precedence to the traders whose bid oroffer first improves the current best bid or offer. While they have time precedence, no othertraders may bid or offer at the new best bid or offer.Traders retain their time precedence as long as they maintain their bid or offer, or until anothertrader accepts it. Afterwards, anyone may bid or offer at the new price and all traders at thatprice will have equal standing.In oral auction markets, bids and offers generally are good only for a moment. Traders say, “Aquote is good only as long as the breath is warm.” In practice, traders who do not honor theirquotes for a reasonable period find that nobody wants to trade with them. Traders maintain their
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precedence by repeating their quotes as often as is necessary to show that they remain interestedin trading. Traders may repeat their quotes continuously in large, very active markets.The time precedence rule encourages traders to improve prices aggressively. Traders who wantto trade ahead of a trader who has time precedence must improve the price. Time precedencerewards aggressive traders by giving them the exclusive right to trade first at the improved price.The time precedence rule thus encourages price competition among traders.LeapfrogThe orange juice concentrate futures market is currently 103.10 cents bid, offered at 103.25cents. (Traders quote prices per pound for 15,000 pound contracts.) Guy is the bidder at 103.10.He has time precedence at that price, and he is defending it. If you want to buy at 103.10, youmust wait until Guy trades. If you want precedence, you must improve the bid to 103.15. Youthen would have price priority over his bid and time precedence over all subsequent bids at103.15. If Guy then wants to reclaim his precedence, he would have to improve the market againby bidding 103.20. Time precedence encourages traders to play leapfrog by jumping over eachother’s prices with improved prices.Good traders carefully consider their leapfrog strategies. For example, if you are willing to bid103.20 and you are confident that Guy will bid 103.20 if you bid 103.15, you may want to skipover 103.15 and bid first at 103.20. If you bid 103.20 and Guy still wants to trade first, he willtake the offer at 103.25. In which case, he will trade immediately and you will still have timeprecedence at 103.20. Of course, if you are quite impatient to trade, your best strategy may be toimmediately take the offer at 103.25.Time precedence is only meaningful when the minimum price increment is not trivially small.The minimum price increment, or tick, is the smallest amount by which a trader may improveprices. It is the incremental price that traders must pay to acquire precedence, through pricepriority, when they do not have time precedence. If it is very small, the time precedence rulegives little privilege to the traders who improve price.The effect of the tick on price competition varies by tick size. If the tick is too small, it decreasesprice competition by weakening the time precedence rule. If this tick is too large, traders arereluctant to improve prices because of the expense. Since the minimum price incrementsignificantly affects market quality, exchanges and regulators pay close attention to it.The Common Cents Stock Pricing Act of 1997In March of 1997, Republican Representative Mike Oxley and others introduced a bill to requirethat US stock markets trade on dollars and cents rather than on dollars and fractions of a dollar.The bill had wide popular support because most people find decimal pricing simpler tounderstand than fractional pricing. The bill never passed. Instead, the exchanges decided toswitch to decimals by themselves.The bill was somewhat remarkable because it represented an attempt by the US Congress tomicromanage trading rules in the stock markets. The exchanges probably decimalized at least inpart to prevent the passage of this bill.
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Chapter 7BrokersBrokers are agents who arrange trades for their clients. Unlike dealers, who trade with theirclients, brokers trade their clients’ orders. Clients usually pay brokers commissions for theirservices.Many brokers are also financial advisors who advise their clients about their investments or theirfinancial plans. They may also provide their clients with investment information. In thesecapacities, they often influence the trading decisions that their clients make.Unless you arrange your own trades, you will use the services of a broker when you implementyour trading strategies. You therefore must understand what brokers can do for you—and toyou—to trade effectively. This chapter describes what brokers do and the problems that tradersmay have with lazy or dishonest brokers.You also need to know what brokers do if you want to be a broker yourself. The discussions inchapter will allow you to better understand how brokers compete with each other for business,and how the best brokers win these competitions.You must understand what brokers do to predict when electronic order matching systems will besuccessful. Automated order-driven execution systems are essentially electronic brokers. Sincetraditional brokers and electronic order matching systems both match buyers to sellers, theycompete with each other. To fully understand either system, you must understand the economicsof both trading systems.Finally, you must understand what brokers do if you are interested in the distinctions thatregulators make between automated order-driven execution systems and traditional brokers.Some automated order-driven execution systems are regulated as exchanges whereas othernearly identical systems are regulated as brokers. If you are interested in these distinctions, youmust ask how the order matching done by traditional brokers differs from the order matchingdone by automated systems.We begin this chapter by considering how brokers serve their clients, how they organize theiroperations, and what determines their profits. We then discuss how the most importantmanagement problem—the principal-agent problem—affects brokers and their clients. Thechapter closes with a discussion about problems that traders can have with dishonest brokers, andhow traders can prevent these problems.7.1 What Brokers DoBrokers arrange trades for their clients. They search for traders who are willing to trade withtheir clients; they represent their clients at exchanges; they arrange for dealers to fill their clients’orders, they introduce their clients to electronic trading systems; and they match their clients’buy and sell orders.Brokers conduct these activities in various types of markets. In order flow markets, brokers takeorders that their clients give them and match them with orders and quotes made by other traders.Exchanges, dealers, or the brokers themselves may operate these markets. Brokers generallysearch for the best price only among traders who are willing to display their limit orders and©2002 Oxford University Press
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quotes in these markets. In block markets, brokers take large client orders and try to find othertraders to fill them. Brokers often must search among traders who have not expressed interest intrading to discover those traders who are willing to trade. In offering markets, brokers distributenew issues and seasoned issues to traders. Brokers must often market these securities to generatebuyer interest. Finally, in merger and acquisition markets, brokers help firms buy other firms.Brokerage firms that engage in large capital transactions are called investment banks. Table 7-1summarizes the different types of brokered transactions.Table 7-1. Types of Brokered TransactionsMarket type
Trades
Market structure
Brokerage role
Order flow
Small to medium sizesin seasoned securitiesand contracts.
Order-driven orquote-driven
Brokers receive orders and matchthem with orders and quotes madeby other traders.
Block
Large sizes inseasoned securitiesand contracts.
Brokered
Brokers receive an order on one sideand must search for traders who willtake the other side. Brokersoccasionally identify both sides.
New andseasonedofferings
Large size offered byan issuer or one ormore large holders.
Brokered
Brokers sell securities to buyers onbehalf of issuers and large holders.
Mergers andacquisitions
Company to company.
Brokered
Brokers find one or both parties.
Only the largest investment banks operate in all types of markets. Most brokerage firmsspecialize in only one or two of these markets.In all markets, brokers are their clients’ agents. Their clients tell them what trades they want tomake, and under what terms they will trade. The brokers then try to arrange the best trades thatthey can subject to the constraints imposed upon them. Generally, clients expect that brokerswill seek the lowest possible prices when buying and the highest possible prices when selling.Clients use brokers to arrange their trades because brokers usually can arrange trades at a muchlower cost than can their clients. The following reasons explain why brokers are low costtraders:•
Brokers can solve clearing and settlement problems at a lower cost than their clients can.
•
Brokers can access exchanges and dealers that their clients cannot access.
•
Brokers generally know better than their clients who might be willing to trade.
•
Brokers are often better negotiators than their clients are.
•
Brokers can represent orders for their clients when their clients are unavailable to representthem themselves.
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7.1.1 Clearing and Settlement among TradersThe most important, but perhaps least appreciated, reason why traders use brokers to arrangetheir trades involves clearing and settlement. Clearing and settlement problems can arisewhenever traders do not settle their trades immediately after they negotiate them. During thetime between arrangement and final settlement, traders risk that their counterparts may notacknowledge their trades, may refuse to settle their trades, or may be financially unable to settletheir trades. Traders therefore are reluctant to trade with people who they do not know aretrustworthy and creditworthy.Without the assistance of brokers, traders would have to check the credit of every trader withwhom they trade. Brokers assist traders by helping them avoid this expensive problem.Brokers solve clearance problems by clearing their clients’ trades. If a client fails toacknowledge a trade, the broker must resolve the problem with the client. The broker thusprotects the trader on the other side of the trade.Brokers solve the settlement problem either by guaranteeing that their clients will settle theirtrades, or by staking their business reputations on whether their clients will settle their trades.When brokers guarantee their clients’ trades, the brokers settle trades that their clients will not.When the brokers simply vouch for their clients, they risk losing future business if they acquire areputation for representing clients who do not settle their trades. In both cases, brokers mustensure that they only represent trustworthy and creditworthy clients. Otherwise, undesirableclients will impose significant costs upon them. The credit function that brokers provide isespecially important in order-driven markets since such markets generally arrange trades amongtotal strangers.Multiplying Credit ChecksWhen traders arrange trades that they intend to settle in the future, they must be confident thattheir counterparts can and will perform. Traders routinely perform credit checks to determinewhether their counterparts are creditworthy.In a market with no brokers, each trader must be prepared to check the credit of every othertrader. If exactly one million traders trade in such a market, the total number of potential creditrelationships is 999,999,000,000, or slightly less than one quad-trillion. In such markets, traderswill only check the credit of traders with whom they intend to trade. They will naturally preferto arrange trades only with traders whose credit they have already checked.Now suppose that this market has brokers who guarantee their clients’ trades. Three types ofcredit relationships are present in this economy:1. Brokers must check the credit of their clients to protect themselves.2. The clients must check the credit of their brokers to ensure that they can trust them. Thesecredit checks may be perfunctory if everyone knows that a broker is creditworthy.3. Each broker must check the credit of every other broker with whom he or she arrangestrades.
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Part IIThe Benefits of TradeThe two chapters in this part discuss how trading benefits individual traders and the entireeconomy. Chapter 8 explains why traders trade. We introduce 32 different types of traders andidentify the benefits that they each obtain from trading. Remarkably, traders often do not clearlyunderstand why they trade. They therefore often trade when they should not or fail to trade whenthey should. Traders who understand why they trade will generally trade more effectively.In Chapter 9, we consider how well functioning markets benefit the entire economy. Theprimary benefits come from informative prices and from market liquidity. We explain how wellfunctioning markets help market-based economies use their resources most efficiently. We alsoconsider a framework for evaluating public policy.
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Chapter 8Why People TradePeople trade to invest, to borrow, to exchange assets, to hedge risks, to distribute risks, togamble, to speculate, and to deal. We consider each of these objectives in this chapter andexplain how markets help traders achieve them.You must understand why people trade to use markets effectively. Markets provide manyvaluable opportunities. To take advantage of them, you must first recognize them.By considering why people trade, you will better understand why you trade and whether youshould trade. Many traders do not fully recognize the reasons why they trade. Consequently,either they pursue inappropriate trading strategies, or they trade when trading iscounterproductive to their true interests. The optimal trading strategy for a given tradingproblem depends on the problem. You cannot trade well if you do not know why you want totrade.Knowing why people trade may also help you determine whether other traders understand whythey are trading. This skill is very important because you can usually distinguish a good moneymanager from a poor one by whether they understand well why they trade. It is also importantbecause traders who do not fully understand why they trade often trade foolishly. If you canidentify such traders, you may be able to profit from their foolishness.If you engage in any trading strategy that depends on the volume of trade, you must understandwhy people trade to interpret volumes properly. Many factors cause people to trade. If yourtrading strategy depends on one of these factors, you will want to examine volumes carefully.However, you must be careful to recognize when other factors may cause people to trade.Otherwise, you may misinterpret volumes and trade when you should not.Markets are successful only when people trade in them. If you want to design new markets, or ifyour business depends on trading in a successful market, you must understand why—and how—people trade.Trading is a zero-sum game in an important accounting sense. In a zero-sum game, the totalgains of the winners are exactly equal to the total losses of the losers. Trading is a zero-sumgame because the combined gains and losses of buyers and sellers always sum to zero. If abuyer profits from a trade, the seller loses the opportunity to profit by the same amount.Likewise, if a buyer loses from a trade, the seller avoids an identical loss.Successful traders must understand the implications of the zero-sum game. To trade profitably,traders must trade with people who will lose. Profit-motivated traders therefore must understandwhy losers trade to know when they should trade.Finally, you must understand why people trade to form well-reasoned opinions about marketstructures. Different structures favor different trader types. If you intend to influence a decisionabout market structure, you should consider first how the decision affects various traders. Thebenefits that traders obtain from markets depend on why they trade. Regulators and otherinterested parties must therefore understand these reasons.
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