Inside Spread Research Articles

Does Trading Anonymously Enhance Liquidity?

Is liquidity better when a trade counterparty’s brokerage firm is unknown (anonymous) or known (transparent)? We examine a quasinatural experiment where some firms switched from transparent to anonymous trading and then, 1 year later, switched back. Our results for inside spread, price impact, and limit order book depth suggest that liquidity improves when anonymous post-trade reporting is introduced and liquidity worsens when anonymous post-trade reporting is reversed.

Liquidity in the FX Market: Empirical Evidence from an Aggregator

In foreign exchange (FX) trading, an aggregator is used to connect traders with liquidity providers (LPs). In an aggregator, a trader receives a continuous stream of bid and ask quotes from a predefined set of LPs, and the difference between the best bid and ask prices over a set of liquidity streams is called an inside spread. In this paper, we empirically study liquidity in an FX aggregator and show that, on average, traders obtain a relatively tight spread with four or five streams; the use of more streams yields a marginal benefit only. For given numbers of liquidity streams, we determine the optimal combinations of streams minimizing the spread. Our findings indicate that most of the traders could — at least in theory reduce the average spread by more than half with the optimal combination of streams, and a trader could save significantly, even up to 0.18 basis points in dollars per €1 traded. However, traders may not be able to fully exploit improvements in spreads because, in practice, the liquidity streams are set by LPs and not by the trader. In addition, we find that Oomen's [Quantitative Finance, 17, 3, (2017)] model for the liquidity dynamics and contract formation process in the aggregator, which can be used to characterize the observed inside spread, fits our empirical data accurately, even under simplistic assumptions.

Latency Arbitrage When Markets Become Faster

We measure the incidence of latency arbitrage for cross-listed stocks around the time of an exogenous shock that made the markets faster. Our sample is from NASDAQ Nordic and consists of Nordic blue chip firms listed and traded in multiple markets. We document a sharp decline in the incidence of cross-market arbitrage opportunities across the Nordic markets for cross-listed stocks from 2009 to 2010 and later. Over the five year sample period 77% of the observed cross-market arbitrage opportunities occurred in 2009 and 13% in 2010 and the remaining 10% spread over the last three years. The inside spread declines by, on average, 14.5 basis points or 53% from 2009 to 2013. Our results point to significant improvements in market efficiency and market quality as a result of the switch to a faster trading system.

Execution in an aggregator

An aggregator is a technology that consolidates liquidity—in the form of bid and ask prices and amounts—from multiple sources into a single unified order book to facilitate ‘best-price’ execution. It is widely used by traders in financial markets, particularly those in the globally fragmented spot currency market. In this paper, I study the properties of execution in an aggregator where multiple liquidity providers (LPs) compete for a trader’s uninformed flow. There are two main contributions. Firstly, I formulate a model for the liquidity dynamics and contract formation process, and use this to characterize key trading metrics such as the observed inside spread in the aggregator, the reject rate due to the so-called ‘last-look’ trade acceptance process, the effective spread that the trader pays, as well as the market share and gross revenues of the LPs. An important observation here is that aggregation induces adverse selection where the LP that receives the trader’s deal request will suffer from the ‘Winner’s curse’, and this effect grows stronger when the trader increases the number of participants in the aggregator. To defend against this, the model allows LPs to adjust the nominal spread they charge or alter the trade acceptance criteria. This interplay is a key determinant of transaction costs. Secondly, I analyse the properties of different execution styles. I show that when the trader splits her order across multiple LPs, a single provider that has quick market access and for whom it is relatively expensive to internalize risk can effectively force all other providers to join her in externalizing the trader’s flow thereby maximizing the market impact and aggregate hedging costs. It is therefore not only the number, but also the type of LP and execution style adopted by the trader that determines transaction costs.

Estimating Boone and Crockett scores for white-tailed deer from simple antler measurements

Antler characteristics are a measure of phenotypic quality and are used by wildlife managers and hunters to assess herd characteristics of white-tailed deer (Odocoileus virginianus). A single metric for antler quality would benefit scientists, wildlife managers, and the hunting public by providing a common gauge. Total antler volume or mass may be the most accurate measure of antler development, but is not practical to obtain from most hunter-harvested animals. The most accepted single measure of antler size is Boone & Crockett (B&C) score. We confirmed the efficacy of gross B&C scores as a predictor of antler mass (g) using antler measurements from 159 captive deer from the Mississippi State University Rusty Dawkins Memorial Deer Unit taken during 1986-1997. Gross B&C score explained 78% of variation in antler mass and was the best 1-variable predictive model. However, calculation of gross B&C score may require � 11 measurements for most harvested adult males. To test the possibility of deriving a simple model to predict gross B&C score from a reduced number of measurements, we used data from 3,532 deer in the Mississippi Magnolia Records Program to examine regression models using inside spread, number of antler points, basal circumference, and main beam length as explanatory variables, because these are the most common antler measurements recorded by wildlife managers. A simple model using total number of points � 2.5 cm and length of main beams explained 77% of variability in gross B&C scores. This model should enable hunters to provide accurate information to biologists regarding antler development in adult age classes, and its relative simplicity may encourage use. 2013 The Wildlife Society.

Repeatability of antler characteristics in mature white-tailed deer in South Texas: consequences of environmental effects

Antler traits are both genetically determined and environmentally influenced. However, the degree to which environmental factors affect antler expression has rarely been quantified. We captured 30 to 150 male white-tailed deer (Odocoileus virginianus) annually at 7 South Texas sites during 1985 to 2009 to determine repeatability of antler traits from a semiarid environment with variable rainfall. Repeatability is defined as the intraclass correlation between repeated measures of the same trait over time. Repeatability was moderate to high (0.42–0.82) for all antler traits. Overall, number of antler points had the lowest repeatability, whereas inside spread of main beams and length of main beams had the highest repeatability. Repeatability of total antler score and number of antler points from sites with variable rainfall was 16% and 24% lower than sites with consistent rainfall, respectively. Sites with variable rainfall had 13–18% higher repeatability when enhanced nutrition was available. Studies of cervids reveal a tendency for lower repeatability of antler traits as the environmental conditions become more variable. The association between repeatability and variable environmental conditions illustrates the magnitude of environmental effects and supports the role of antlers as an honest advertisement of individual condition or quality. Our results help to understand potential of microevolution in antlers and have implications for sexual selection and harvest management.

Three Principles for Market-Based Credit Regulation

A key lesson of the financial crisis 2007-09 is that the Bagehot Rule, “lend freely but at a high rate,” needs to be updated for the emerging market-based credit system. A modern rule is suggested: Markets, not Banks; Outside spread, not Inside spread; Core, not Periphery.

Is Best Really Better? Internalization of Orders in an Open Limit Order Book

We study the market quality of the Xetra BEST system operated by Deutsche Borse AG, an internalization system designed as part of an open limit order book, which guarantees a price improvement over the inside spread in the Xetra order book. We develop a structural model of this dual market environment and show that adverse selection costs of internalized trades are significantly lower than those of regular order book trades while realized spreads are significantly larger. The cost savings of the internalizer are larger than the mandatory price improvement, suggesting that internalization can be profitable for both customer and internalizer.

Tick Size Regulation, Intermarket Competition and Sub-Penny Trading

The minimum price variation, or tick size, is at the center of the current regulatory debate as it aects competition for liquidity provision in limit order books. A reduction in the tick size is …rstly shown to have a detrimental eect on the quality of illiquid stocks as it worsens both spread and depth; but it bene…ts liquid stocks as it reduces inside spread and increases market depth. Then we build a dual-market model and examine how competition between two public limit order books (PLB) ends up with liquidity concentration on the market with a smaller tick size. Finally, we adapt this dual-market framework into a model with a PLB competing with another book char- acterized by a smaller tick size, namely Internalization Pool (IP), accessible only to broker-dealers. In this way we are able to investigate the issue of sub-penny trading that is discussed in the SEC concept release on Equity Market Structure (2010). Our …ndings are as follows: when broker-dealers are able to use an IP to provide price improvement by a fraction of the tick size, the quality of a PLB is considerably wors- ened for illiquid low priced stocks; for liquid stocks, however, the introduction of an IP fosters competition and improves both spread and depth. In addition our model predicts that broker-dealers use IP more intensively for low priced liquid stocks.

What pieces of limit order book information matter in explaining order choice by patient and impatient traders?

In this paper, we extend the existing empirical evidence on the relationship between the state of the limit order book (LOB) and order choice. Our contribution is twofold: first, we propose a sequential ordered probit (SOP) model which allows studying patient and impatient traders’ choices separately; second, we consider two pieces of LOB information, the best quotes and the book beyond the best quotes. We find that both pieces of LOB information explain the degree of patience of an incoming trader and, afterwards, its order choice. Nonetheless, the best quotes concentrate most of the explanatory power of the LOB. The shape of the book beyond the best quotes is crucial in explaining the aggressiveness of patient (limit order) traders, while impatient (market order) traders base their decisions primarily on the best quotes. Patient traders’ choices depend more on the state of the LOB on the same side of the market, while impatient traders mostly look at the state of the LOB on the opposite side. The aggressiveness of both types of traders augments with the inside spread. However, patient (impatient) traders submit more (less) aggressive limit (market) orders when the depth of the own (opposite) best quote and the length of the own (opposite) side of the book increase. We also find that higher depth away from the best ask (bid) quote may signal that this quote is ‘too low (high)’, causing incoming impatient buyers (sellers) to be more aggressive and incoming patient sellers (buyers) to be more conservative.

The information content of an open limit‐order book

AbstractUsing data from the Australian Stock Exchange, the authors assess the information content of an open limit‐order book with a particular focus on the incremental information contained in the limit orders behind the best bid and offer. The authors find that the order book is moderately informative—its contribution to price discovery is approximately 22%. The remaining 78% is from the best bid and offer prices on the book and the last transaction price. Furthermore, the authors find that order imbalances between the demand and supply schedules along the book are significantly related to future short‐term returns, even after controlling for the autocorrelations in return, the inside spread, and the trade imbalance. ©2008 Wiley Periodicals, Inc. Jrl Fut Mark 29:16–41, 2009

LIQUIDITY COMMONALITY BEYOND BEST PRICES

AbstractPrevious market microstructure research focuses on commonality in liquidity at the inside spread. However, liquidity at the inside spread only determines the systematic liquidity risk of small and medium trades. We study commonality in displayed liquidity beyond best prices, which determines the systematic liquidity risk of large trades. We show that it is much larger than commonality at the inside spread. The deeper we look into the order book, the higher is the level of commonality. In addition, it rises in the morning and when markets fall.

Electronic Communication Networks, Market Makers, and the Components of the Bid-Ask Spread

We investigate why trading costs through Electronic Communication Networks (ECNs) are lower than trading costs with market makers through estimating the components of the bid-ask spread. Additionally, we show how the composition and size of bid-ask spreads change with the market environment. We find the adverse selection cost component of the bid-ask spread to be lower when ECNs are alone at the inside compared to when market makers are alone at the inside. The magnitude or size of the inside spread is largest during periods of high volatility but smallest when stock returns approach zero.

Does market maker competition affect the response to insider trading?

This study investigates the impact of market maker competition on the relationship between equity bid-ask spreads and informed trading risk from reported insider purchases. It is the first study to provide evidence that the relationship between inside spreads and insider purchases is stronger when there are fewer market makers or more concentrated market making shares. No evidence is found of a relationship between inside ask depth and reported insider purchases. The results are consistent with theoretical expectations that spreads will respond more to informed trading risk under less competitive market making conditions. However, the results are contrary to the DuPont (2000) prediction that market makers alter depth more than spread in response to informed trading risk.

Nonlinear dynamics in Nasdaq dealer quotes

A nonlinear dynamic model for the quotes issued by Nasdaq dealers is considered. The model focusses on the top two electronic communication networks (ECNs), Island and Instinet, and the three most active market makers for a sample of twenty stocks. The model extends the standard linear vector error correction model for price discovery in three different ways. First, quote adjustments are set relative to the inside quote, i.e. the best bid and ask in the market. Second, dealers react to the inside spread. Third, adjustments differ according to which dealer is currently at the inside. Adjustments are different if an ECN is currently at the inside compared to an individual dealer. This difference is attributed to the asymmetric information among dealers. Price discovery dynamics are studied using generalized impulse response functions.

Cournot model of brokered FX trading

This paper develops a Cournot model of rival dealers placing limit orders with a broker, who in turn makes a market by acting as a liaison between dealers. The broker's limit-book lists the various prices and quantities at which dealers are willing to exchange currency vis-à-vis electronic broking. The size and volatility of the inside spread is simulated relative to dealer entry–exit and the price elasticity of linear order arrival functions. Our simulations reveal non-linear price dynamics from dealer participation in market development, with an additional rival narrowing the inside spread by 1.82% while diminishing its volatility. These findings may shed some light on the “excess volatility puzzle” raised by Killeen, Lyons and Moore (forthcoming) as to why price behavior under flexible exchange rate regimes is significantly more volatile than macro fundamentals would suggest.

Does Risk Aversion Vary During the Year? Evidence from Bid-Ask Spreads

We document previously undiscovered seasonal patterns in bid-ask spreads which are economically and statistically significant. After controlling for well-known conditional effects on spreads, such as risk, liquidity, and asymmetric information effects, we find that spreads based on individual dealer quotes are on average 20 basis points wider during the fall and winter relative to their unconditional average of 180 basis points. Furthermore, inside spreads are about 20 basis points narrower during these periods when spreads based on individual quotes are wider. We posit that these opposing patterns in quoted spreads and inside spreads are the logical outcome of seasonally changing risk aversion among a subset of market makers. When we consider periods of high market volatility, we find that the economic and statistical significance of the seasonal patterns in spreads intensify, as they should if they arise for reasons related to risk aversion. Our findings are robust to a wide range of tests and specification changes. Independent of the cause, researchers studying spreads need to be mindful of the strong seasonal patterns in individual dealer spreads and inside spreads, as does any market participant who has discretion in the timing of his trades.

Can Sub-Penny Pricing Reduce Trading Costs?

We examine the effect of tick size on quotation behavior in a naturally-controlled experimental setting. Of the top six Electronic Communications Networks (ECNs), three allow sub-penny quotes (group S) and three do not (group P). For a sample of stocks that trade on all six of these ECNs, we find that group S ECNs have narrower spreads than group P ECNs, especially for low-price stocks. Even after correcting for left-truncation and price discreteness, we find that spreads for the same stocks are tighter on group S ECNs, suggesting that a smaller tick size fosters greater price competition. We find that the one penny tick is frequently a binding constraint on the inside spread and that the relaxation of the binding constraint would result in a 0.7 cent (16%) reduction in the inside spread.

Why is There Heterogeneity Among Dealers' Behavior during the Nasdaq Preopening Session?

Order preferencing enables a market-maker to execute captive order flow off the primary market. This practice is known to generate wider spreads due to its anti-competitive effects. It also increased inventory risks for dealers. The Nasdaq preopening offers a laboratory to test whether market-makers use non-binding prices as a tool to control their inventory position. We find that the most preferred category of market-makers - called 'the wholesalers' - participate the most actively in the communication game taking place during the preopening session. This category contributes, however, the least to the price discovery process. Besides, unlike other dealers, wholesalers communicate more on stocks with a high degree of order preferencing and are more likely to be on the inside spread when communicating more. These findings suggest that they initiate signals to reduce inventory imbalances due to preferencing. Finally, we find that the reversal of the wholesalers' price is the largest at the opening, which supports the hypothesis that they are the most exposed to inventory imbalances. Moreover, the best prices (the NBBO) also have a transitory component at the opening, which corroborates our main hypothesis that the Nasdaq non-trading mechanism incorporates inventory information into prices.

What Pieces of Limit Order Book Information Matter in Explaining Order Choice by Patient and Impatient Traders?

In this paper, we extend the existing empirical evidence on the relationship between the state of the limit order book (LOB) and order choice. Our contribution is twofold: first, we propose a sequential ordered probit (SOP) model which allows studying patient and impatient traders' choices separately; second, we consider two pieces of LOB information, the best quotes and the book beyond the best quotes. We find that both pieces of LOB information explain the degree of patience of an incoming trader and, afterwards, its order choice. Nonetheless, the best quotes concentrate most of the explanatory power of the LOB. The shape of the book beyond the best quotes is crucial in explaining the aggressiveness of patient (limit order) traders, while impatient (market order) traders base their decisions primarily on the best quotes. Patient traders' choices depend more on the state of the LOB on the same side of the market, while impatient traders mostly look at the state of the LOB on the opposite side. The aggressiveness of both types of traders augments with the inside spread. However, patient (impatient) traders submit more (less) aggressive limit (market) orders when the depth of the own (opposite) best quote and the length of the own (opposite) side of the book increase. We also find that higher depth away from the best ask (bid) quote may signal that this quote is 'too low (high)', causing incoming impatient buyers (sellers) to be more aggressive and incoming patient sellers (buyers) to be more conservative.