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How to Open a Financial Market when Institutional Traders are

Present

Michael S. Pagano

Villanova University

Michael.Pagano@villanova.edu

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Is trading this simple? …

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or slightly more difficult ??

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What Motivates Trading?

1. New information (news)

2. Liquidity needs

3. Divergent expectations (people agree to disagree)

4. Technical (noise) trading

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Fundamental Financing Channels

Firm Investor

Firm InvestorIB / CB

Buyer Seller

Agent

Exchange

or Market Maker

Agent

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Purposes of Financial Markets

• Set Prices for financial assets

• Exchange Information

• Raise Capital for Issuers (Primary Mkt)

• Liquidity for Investors (Secondary Mkt)

• Vehicle for Managing Risk

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Major Trading Issues

• Liquidity

• Price & Quantity Discovery

• Volatility

• Transaction Costs

• Trading Profits for Market Makers

• Net Investment Returns

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Order Revelation in a Financial Market

“Bookbuilding” is the process of:– revealing orders and/or trades, – forming an active market with numerous

traders, – discovering the asset’s price (price

discovery), and– deepening the order “book” and/or building

trading volume (quantity discovery).

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Challenges of Order Revelation

• It is not a simple process.• Existence of an order is information that

can be used against the trader submitting the order (i.e., it is like a “free” option given to other traders).

• Adverse price changes can occur due to:– Market Impact of large orders,

– Front-running, and

– Mis-pricing of early orders.

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Challenges for Large Traders

• Large, institutional traders know that their actions can impact market prices.

• Large traders are more likely to suffer “ex post” regret about their trades.

• Therefore, many large traders do not fully reveal their order sizes, thus creating strong, latent demand to buy and/or sell.

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A Two-Sided Market with Unequal Orders

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“Most Inefficient” Outcome via Order Shading

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“Most Efficient” Outcome via Open Book

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Building to an Efficient Outcome with Multiple Orders

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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 Mechanism

Informed

Is p*>offeror p*<bid?

Orders Come from 3 Types of Traders

LiquidityOrder Flow

Quotes,Prices,Volume

Technical Trading

Is there a trend/pattern?

P*

Do the informedTraders agree with

each other? maybe not!

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$21.00

$22.00

$23.00

$24.00

$25.00

$26.00

$27.00

$28.00

Ask

Bid

P*

Day 1 Day 2

De-Briefing: P*, Best Bid and Offer Quotes, and Price Impact

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Key Questions

• How did you do in terms of achieving your goal? (e.g., did you get the shares at a “good” price?)

• What types of orders / trading strategies worked best? Which worked worst?

• What do you think caused the bid-ask prices to diverge from the equilibrium P* values?

• Did you shade your orders or did you feel comfortable submitting large orders?