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FMA Doctoral Consortium Market Microstructure Larry Harris USC and SEC October 16, 2002 San 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 shortterm 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 zerosum 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