The Equity Markets Microstructure SeminarBaruch College11-12 November 2004

Market Microstructure: Seven Key Lessons

Wayne H. Wagner, ChairmanPlexus Group, Inc.

a subsidiary of JPMorgan Chase Bank

Seven Key Lessons

1. Good markets are essential to a robust economy.

2. Uninformed traders lose to informed traders.

3. Good market design is critical.

4. Technology is changing markets radically.

5. The important costs of trading are hidden.

6. It’s not a zero sum game.

7. Markets can fail.

1. Good Markets Are Essential to a Robust Economy

Efficient pricing of assets and expectations.• Aggregation and interaction of information• Expression of choices• Prices allocate resources for the futurePricing of risk and risk transfer• Fear and greed: moral hazard• Transference of risk (e.g. options)• Arbitrage of risk (rule of one price)Liquidity:• Easily exchangeable assets are worth more.• Facilitation of liquidity Prices reflect all the above

Echoes of Friedrich Hayek

Information costs are reduced by the existence of large numbers of buyers and sellers. Under these conditions, prices embody the same information that would require large search costs by individual buyers and sellers in the absence of an organized market.

Douglas North

The market is smarter than any participant in it!

Jack Treynor

2. Uninformed Traders Lose to Informed Traders

Dem dat know, know dat they know;

Dem dat don’t know, don’t know dey don’t know.

Maria Muldaur, lightly talented barroom singer who attained one fleeting moment of fame

for “Midnight at the Oasis”

“And dat’s the name of the game.”

Mike Epstein, highly talented NASDAQ market maker MIT professor, possibly interesting barroom singer,

who is here and now attaining one fleeting moment of fame.

Thank Heaven for the Uninformed Traders!

Meet an Informed TraderHi! I’m an informed trader and I’m here to help the market

efficiently price assets!

Meet an Informed Trader

Meet an Uninformed

Trader

2. Uninformed Traders Lose to Informed Traders?

• Informed traders hide as uninformed traders.

• Many uninformed traders think they're informed.

• A manager who’s right 55% of the time is an investment genius. He doesn’t know which ideas he’s “informed” about.

• YET there are informed traders, informed mostly about pending supply & demand imbalance.

• Therefore dealers have to act without knowing whether the trader is informed or not.

Some sheep are wolves.

Some wolves are sheep.

Some don’t know when they’re wolves or sheep.

There really are wolves!

All sheep are wolves until proven otherwise.

Who Am I Trading With?

Who Am I Trading With?

Who Am I Trading With?

Wagner’s Simple Minded Explanation of Dealer Behavior when Informed Traders Disguise Themselves

Long too many shares:

Short too many shares:

I can’t distinguish between informed and uninformed. The fundamental problem is risk control.

Encourage buyers & discourage more sellers with low quotes.

Encourage sellers & discourage more buyers with high quotes.

I’ll trade with anybody, if it reduces my inventory risk to within my tolerance bands.

3. Good Market Design is Critical!

Bad design can create large, unexpected deviations from expectations:

Optimark: failed to deliver value to users.

California Energy Market: successful at delivering value to abusers.

Good design can create large, unexpected deviations from expectations:

Decimalization and Order Handling Rules.

Decimalization and Order Handling Rules

Two major changes

Many more price points

Ability for “naturals” to compete with dealers via limit orders

Unintended effects (or were they really that clever?):

Enhanced control of the order by the buyside

Disintermediation of the broker: what’s the value proposition now?

Less leakage of trading information

Lower trading costs!

Costs Are Already Coming Down!

-250 -200 -150 -100 -50 0

ALL EMERGINGMARKETS

EMERGING EUROPE

ALL MARKETS

ALL DEVELOPEDMARKETS

UNITED STATES NASDAQ

DEVELOPEDEUROPE

UNITED STATES NYSE

4th qtr 2000 vs 4th qtr 2003

Source: Plexus Group, 2004

• The agency conflicts inherent in a “relationship” market are reduced.

• Transaction cost hurdles to superior performance are smaller.• Profitable new strategies, e.g. stat/arb, are now possible.• Technology is enabling completely integrated end-to-end

investment processes: Integrated Decision Models Order Management Systems Algorithmic Trading Engines FIX Connectivity Competition among markets Straight Through Processing

• Disintermediation is redefining the role of the dealer.

Investors Are Taking Control of the Trading Process

4. Technology Is Radically Changing Markets

“Darwinian adaptation,” triggered by technological and regulatory aegis, is completely changing the markets.

Institutional trading practices today are radically different than they were just 3-4 years ago.

Unattractive market structures are losers. They die.

Investors are winners.

An Manual Investment Management Process( Circa 1920 - 1990 )

Which securities to buy?

How much to buy?

How to trade?

Phone sls trader

Decision Process

Write up order

Send to booth

Walk to floor

Execute

Inform sls trader

Inform customer

Inform back office

Clearing

Settlement

Handoff to brokering

Handoff to accounting

Execution Process

Settlement Process

Time frame measured in days

What’s Wrong with This Picture??

• Stuck in a Graham and Dodd world.

• Absolutely casual about elapsed time.

• Sequential solutions, instead of jointly determined. Ignorant of co-dependencies.

E.g.: trade cost affects outcomes of security picks.

• Prone to error at every step.

• Too many steps involved; prone to sub-optimization.

• Too many agents involved; prone to information leakage to “prying eyes.”

• Excessively costly!

A Fully Integrated Decision, Execution and Settlement Process

Which securities to buy?

How much to buy?

How to trade?

Integrated Decision Process

Check for liquidity

Route to market

Execute

Update OMS, Accounting

Automated clearing, settlement

Auto-notification of interested parties

Integrated Execution Process

Integrated Accounting Process

Circa 2010?

5. The Important Costs of Trading Are Hidden

Source: Plexus Group, 2003

Commission 5 ¢ (17 bp)

ImpactImpact10 ¢ (34 bp)10 ¢ (34 bp)

Delay23 ¢ (77 bp)

Missed Trades9 ¢ (29 bp)

Best Execution Is Much More than an Exercise in Compliance or Monitoring Agents

The CFA-Institute Trade Management Guidelines¹ define Best Execution as:

The Trading Process Most Likely to Maximize the Value of Client Portfolios.

This is a manager’s duty, akin to prudency. Delay and opportunity costs are exclusively the responsibility of the buyside.

6. Not a Zero Sum Game!

A Nash equilibrium, not “winner takes all” situation.

All players consider other players interests as they design their strategies. All solve for best personal outcome given the competition. Open to new players who join only if they see a positive personal outcome.

Market design should: Favor those who perform research, Charge those who demand liquidity, and Encourage those willing to provide liquidity for trading profits.

7. Markets Can Fail! The Unforgettable Lesson of the 1987 Crash

Markets work only when willing buyers meet willing sellers. When either group is scarce to the point of absence, markets cannot find clearing prices. 1987: all sellers, no buyers.

Markets balance fear and greed. Moral Hazard: Fear is an absolute necessity for functional markets. Portfolio insurance created “riskless” investments.

When markets fail, the rules of economics are co-opted by psychologically driven behavior. Fear comes back with overwhelming power. Market failure created the risk needed to rebalance the greed.

7. Markets Can Fail!

The spirit of speculation is anarchic, irreverent, and anti-hierarchic. It loves freedom, detests cant, and abhors restrictions. ...

[S]peculation has established itself as the most demonic of economic activities. Although profoundly secular, speculation is not simply about greed. The essence of speculation remains a Utopian yearning for freedom and equality which counterbalances the drab rationalistic materialism of the modern economic system.

Throughout its many manifestations, the speculative mania has always been, and remains to this day, the Carnival of Capitalism, a “Feast of Fools.”

Edward ChancellorDevil Take the Hindmost1999

Thank Heaven(?) for the Uninformed Traders!

The Equity Markets Microstructure SeminarBaruch College11-12 November 2004

Market Microstructure: Seven Key Lessons

Wayne H. Wagner, ChairmanPlexus Group, Inc.

a subsidiary of JPMorgan Chase Bank