Transcript What market features reduce uncertainty?

Markets and Microstructure
Maureen O’Hara
Cornell University
June 2007
The Big Picture
Markets provide liquidity and price discovery
Investors care about risk, return and uncertainty
Microstructure influences the provision and cost of
liquidity, the risks of price discovery, and the
resolution of uncertainty
My talk today
My talk today is about the role and design of financial markets.
These issues are particularly relevant for China as its markets
evolve and play an even greater role in development.
A particular theme that I want to address is that the design of the
market is fundamental to the success of the market. I also want
to offer some comments on the current stock market “bubble”
and how it can be tempered.
The Role of Markets
 What markets should do
 Allocate capital to firms for investment purposes
• Stock prices should be signals to firms about the markets view of
their future prospects.
 Provide an investment vehicle for traders
 What markets should not do
 Become a “casino” for individual looking to speculate
Some themes in microstructure
 Information
 Transactions costs
Information
 In an efficient market, the price of a security should
reflect the value of the underlying assets.
 Value = current value + expected future opportunities
 More technically, in an efficient market a security price
follows a martingale.
“No Free Lunch”
How does information get into price?
 Public information - accounting data, news stories,
company announcements
 Influences all traders’ behavior
 Private information
 Influences some traders’ behavior
Trades may be a signal of private information
Learning
 If trades can be correlated with new information, then
market data can be informative
 Preponderance of buy orders signals good information
 Preponderance of sell orders signals bad information
 Volume may be indicative of existence of new information.
 So traders learn from market data and update beliefs
Implication for market design
 Designing markets to facilitate learning fosters price
discovery.
 When traders have difficulty learning, then assets appear
riskier and uninformed traders demand less. This can slow
the adjustment of prices to new information and increase
the cost of capital for companies
Markets also provide liquidity to traders
 Buyers and sellers do not always arrive
simultaneously – the time dimension of trading
 Quantity demanded may not instantaneously equal
quantity supplied – the size dimension
 Ease of trading may be periodic – buyers and sellers
may disappear
 A particular concern in a bubble.
Liquidity has many dimensions
 Spreads
 Price impact of trades
 Ability to trade large quantities without affecting the
price
 Ability to trade quickly
These are all transactions costs of trading. Liquid
markets have enormous advantages over illiquid
markets, and liquidity begets more liquidity.
Implication for market design
Designing markets to foster liquidity lowers the cost of
trading and increases the return to investors
Greater liquidity may also lower the cost of capital
for firms.
Markets can also reduce uncertainty
 Uncertainty is not the same thing as risk
 The distinction between known odds and unknown odds
• People prefer situations where the odds are known –
the Ellsberg paradox
When uncertainty is large, traders won’t participate.
What causes uncertainty?
 Maybe the company doesn’t exist…..
 Maybe the seller will take my money and not give me
the stock
 Maybe the company is lying about its financial
condition…
 Maybe the price is being manipulated by other traders
Implication for market design
 Designing markets to reduce uncertainty can induce
greater participation in markets.
 More participation facilitates risk sharing and lowers the
equity risk premium
 More participation creates liquidity and lowers transactions
costs
 More participation generates greater volume and exchanges
make more money
Goals of market design
 Designing markets to facilitate learning fosters price
discovery.
 Designing markets to foster liquidity lowers the cost of trading
and increases the return to investors
 Designing markets to reduce uncertainty can induce greater
participation in markets.
 Designing markets to reduce gambling motives can improve
stability.
What does the optimal microstructure look like?
What market features facilitate learning
and price discovery?
 Transparency of trades and quotes
 Ability to short sell
 Timely market data – volume, depths, etc.
 Derivative markets
What market features facilitate liquidity?
 Lower fees and access charges
 Tick size issues
 Institutional investor presence
 Designated market makers (particularly for SMEs)
 Periodic call markets
 Efficient trading systems
 Non-fragmented order flow or extremely good market
linkages
What market features reduce uncertainty?
 Listing requirements – higher for SMEs
 Accounting standards and corporate governance rules
 Delisting protocols
 Trade monitoring
 Trading halts, circuit breakers
 Insider trading rules
 Best execution requirements
 Clearing and settlement rules
What market features reduce “gambling”?
 Wealth limits on investors
 Super margin requirements?
 Greater regulation to prevent manipulation, insider
trading
 Allow short selling
 Greater institutional presence
 Generally helped by the allowing futures and other hedging
products
 Price limits
 Capital gains taxes for short term trading
Bubble problems
 Trees do not grow to the sky
 Stock prices will fall (probably dramatically) because they
are no longer tied to economic fundamentals
 Allowing individuals access to foreign investments
would allow some of the excess demand to dissipate
 Raising interest rates would also provide some alternatives,
but this raises other issues
 Stamp taxes are not generally a good idea .
 Cross-holdings of stocks by other companies,
borrowing by investors on other assets, and scaring
institutions from the market result in irrational pricing
The outlook for China
 Chinese markets are rapidly developing, but the microstructure
must catch up.
 Very real risk that a bubble is developing that will cause damage to
both investors and the market
 Still largely a retail market, but greater participation by
institutions would create more liquidity and more stability for
stocks.
 Greater investor protection is needed.
 The important role of short selling.
 Need to develop markets, products for hedging and risk
reduction.
The Role of Microstructure Research
 Microstructure research can evaluate the performance
of the market
 Determine its efficiency and liquidity
 Investigate the behavior of alternative market
structures and suggest new market initiatives.
 Predicting the impact of introducing stock index futures
 Suggest trading strategies and ways to minimize
trading costs.
 Highlight problems and potential abuses in markets
 Nasdaq price fixing came to light from research
Conclusions
 I hope my book will encourage new and important
research into the microstructure of the Chinese
markets.
 Thank you