FMA Doctoral ConsortiumMarket Microstructure

Larry HarrisUSC and SEC

October 16, 2002San Antonio

An Introductory Caution

• Data resources in market microstructure are especially strong and seductive.

• Data mining can be very productive.

– But you can never fully satisfy the referee.

Tools and Problems

• Problem-oriented approaches are most interesting and satisfying.

• Tools versus problems

Positive and Normative Economics• Trader behavior depends on market

structure.

• Choosing the best market structure depends on trader behavior.

Trader Behavior

• Buy-side traders

• Gamblers

• Dealers

• Bluffers

• Order anticipators

• Informed traders

Buy-side Order Strategy

• How Should Traders Trade?

– Break up orders?

– Timing?

– Limit or market?

– Display or hide?

• Theory on these questions has been started but good empirical work is still scarce.

Buy-side Order Strategy

• Search strategies depend on trading problems.

• We don’t know very much about trading problems.

• Why do people trade?

Buy-side Order Strategy

• Trading is a search problem.

• We need better models of the time dimension of liquidity.

– Liquidity is more than bid/ask spread.

• Empirical studies focus too much on market order traders.

Gamblers

• CBOE’s “Power paks”

• Long-term relation between informed prices and uninformed traders.

Dealer Behavior

• Generally well worked over.

• We need to better understand the relation between dealing and short-term speculation.

Bluffers and Manipulators

• Bluffers make the provision of liquidity “efficient.”

• Derivative pricing problems.

– Cash settlement.

– Crossing markets

Order Anticipators

• Traders can profit from serially correlated order flows.

• What causes serially correlated order flows?

• Should this be regulated?

Informed traders

• Value traders

– Winner’s curse

• News traders

– How do you know whether the information is in the price?

• Limits to arbitrage

Market Structure

• Best markets

• Problems with competition

• Regulatory issues

What Market Structure Is Best?• Continuous versus batch

mechanisms.

• Electronic versus open outcry.

• Order-driven public auction markets versus quote-driven dealer markets.

• Segmentation versus consolidation.

Analytic Issues

• Theoretical comparisons must model endogenous order flows.

• Empirical comparisons must keep everything else constant.

– Side-by-side comparisons must model clientele issues.

Market Criteria

• Of what benefit are informative prices over short horizons?

• Of what benefit are continuous markets?

How Do We Tradeoff…

• Fast versus slow markets?

• Simplicity and complexity?

• Dealers versus limit order traders?

• Competition for best price and competition in exchange services?

Regulatory Issues

• Agency problems with brokers.

• Order-flow externality.

• How should we regulate trading in general?

• Who should pay for regulation?

• What is the value of innovation?

• Specialists

Economics of Coordination

• Externalities

• Problems

– Market data fees

– Trade-through rules

– Transparency

– Secondary precedence rules

– Circuit breakers

Agency Problems

• Payments-for-order flow

• Penny stock problems

– Whack-a-mole

• Churning

– Client suitability

Current Issues

• Analysts

– What is the value of advice in a zero-sum game?

• IPO problems

• What is an exchange?

• Market center fees

• Fast, slow and traded through

Related Topics

• Liquidity and asset pricing

– The mutual fund problem

• Liquidity and contract design

– Where is the line between public financing and private financing?

• Macro- and micro- concepts of liquidity.

Conclusion

• Very exciting time to work in Finance.

• Still lots of good topics.

• Good luck!

Read the Press

• SEC web page

• Securities Week

• Pension and Investments Age

• Investment Dealer’s Digest