Lecture 03:

Market Structure II
• Overview of Australian stock markets
• How was trading conducted on NYSE?
• Developments in markets: fragmentation and speed
• Alternative Trading System and dark pools
• Complex orders

Dr. Yuanji Wen FINA3307

Yuanji.wen@uwa.edu.au Trading in Securities
Markets
Recap

 Quote-driven markets vs Order-driven markets

• In pure quote-driven markets, public traders cannot arrange
trades among themselves.
• In an order driven auction market, all traders issue orders to
the exchange.

Buyer Seller
A D
Buyer Seller
A D

Dealer Trading Rules

Buyer Seller Buyer

Bid @ $12.00
C C B
Offer @ $12.10

The University of Western Australia 2

Recap

 Order precedence rule

 Trade pricing rule

• Uniform pricing rule: used in single price auction
• Discriminatory pricing rule: used in limit order book market

The University of Western Australia 3

Related chapters

 Teall, 2018, Chp 2, 3.6 and 5.2

 Hasbrouck, 2020, Chp 5, 7, 8, 14

The University of Western Australia 5

(pick up from last week)
How is trading conducted on ASX?

 Pre_Open: single price

auction determines open price
 Open: continuous double
auction (limit order book
market) utilizes discriminatory
pricing rule.
 Pre_CSPA/ CSPA: close
single price auction
determines close price

 See document attached to

tutorial.

The University of Western Australia 6

Australian equity markets

 Source: https://www.asx.com.au/services/trading-services/australian-cash-market-report.htm

The University of Western Australia 10

Australian Trading Venues

 Australia Trade Match

• Exchanges Centre Point

• Crossing systems (as of 202107)

The University of Western Australia

 How was trading conducted on the NYSE?

 A bit of history…….
• 1792, May 12, the NYSE was
founded in New York City
• 1867: The stock "ticker" is
invented, revolutionizing the
market by allowing investors to get
current stock prices anywhere.
• 1870 – 1970, ticker tape
• 1878: The first telephone is installed
on the floor of the exchange, two
years after Alexander Graham Bell's
successful tests of the new
technology.

Source: http://edison.rutgers.edu/ticker.htm
https://en.wikipedia.org/wiki/Ticker_tape
https://www.voanews.com/usa/nyse-200-years-market-ups-downs
The University of Western Australia 12
How was trading conducted on the NYSE?

 Specialist system was established in the 1930s and it lasted

until 2006. Then it is replaced by the designated market
makers (DMMs).
 Prior to 2006, most trades are conducted on the floor by
“trading crowd”.

The University of Western Australia 13

Video on the NYSE specialists –
LMS Week 03 folder

The University of Western Australia 14

How was trading conducted on the NYSE?

 One specialist for each stock

 They have..
• Affirmative obligations to offer liquidity - traders of last
resort.
• Negative obligations – yield to public orders.

 Maintained a book containing all unexecuted

securities.

 Has significant trading advantages relative to

other market participants.

The University of Western Australia 15

How is trading conducted on the NYSE?
 In 2006, NYSE was demutualized and merged with
Archipelago. Significant technology overhaul!
• The role of the specialist has been passed on to designated market
makers (DMMs). DMMs no longer possess trading advantages as
they have no special access to order books.
• SuperDOT trading system is replaced by NYSE Super Display
Book System (SDBK) for routing and processing orders.
– Customers are able to execute orders in as quickly as 5
milliseconds.
– No longer needed to present orders at the trading post by a
commission broker.
 “Today, the changes in the U.S. equity markets can be characterized by two words —
fragmentation and speed .”
• Brett Redfearn, Director, Division of Trading and Market, SEC, U.S. June 3, 2019
• https://www.sec.gov/news/speech/speech-redfearn-060319

The University of Western Australia 17

“Market makers” in an order-driven market

 Source: NYSE

The University of Western Australia 18

Development in markets:
Fragmentation & speed

The University of Western Australia 19

Development in markets:
Fragmentation & speed
 Late 90s and early 2000s saw most world stock exchanges
demutualise and go-public.

 In the most recent decade,

• Markets have become more fragmented than before.
– In US, SEC approved some stock exchanges (e.g., IEX)
– In Australia, Chi-X launched its trading in 2011.
• Numerous new entrants in the market.
– Alternative Trading Systems (ATS) in US
– Crossing systems in Australia

• New types of traders focusing on speed and technology

– E.g., HFT traders
• Innovation in the way trading is done, e.g. periodic auction

The University of Western Australia 21

US Market:
12 stock exchanges + over 50 ATSs
Stock Monthly Volume by Exchange, 20190329
 NYSE + NASDAQ
2.56% • Roughly 13% ONLY!
7.62%
16.33%

5.08%  Biggest: AMEX

7.57% 6.53%
(American Stock Exchange)
• 16.3%
9.99%

 NYSE + NASDAQ +
12.13%

AMEX ~30%
13.00% 6.03%

10.83%

2.32%

Amex Arca Bats-Y Bats-Z Boston CHX Source: SEC website

Edge-A Edge-X NSX NYSE Nasdaq Phlx

The University of Western Australia 22

Alternative Trading Systems (ATS)
 Trading venue that is not registered with the SEC as an
exchange. It centralizes, crosses, matches and executes
trading interest.
• Provide electronic forums for linking dealers with each other and
with institutional investors.
• An ATS might be defined as an exchange that does not operate as
a self-regulatory body.

 Types of ATS:
• Electronic Communication Networks (ECNs);
– Example: Instinet, Archipelago.
• Dark Pools and "Crossing Networks";
• Internalization Crossing Networks;
• Voice-Brokered Third Party Matching.

The University of Western Australia 23

Dark Pools
 Dark pools are venues/forums where buyers and sellers trade
securities without displaying orders to market participants.
• Function in parallel with traditional markets.

 Classified by operator:
• Exchange-owned ones such as
– Australia: ASX Centre Point
– Europe: BATS Europe Dark Pool and Turquoise Dark

• Broker-operated ones such as

– UBS ATS, Credit Suisse’s CrossFinder, Goldman Sachs’
Sigma X
– Australia: called Crossing Systems

The University of Western Australia

Dark Pools
 Classified by execution algorithm:
• Mid-quote execution (one-sided market): Australia and prevails
in European markets, some US dark pools
• Dark limit order book trading (two-sided market): US
Types Examples in US Typical Features
One-sided market ITG Posit, Liquidnet, Instinet Mostly owned by agency
brokers and exchanges;
typically execute orders at
midpoint or VWAP of
exchanges, and customer-
to-customer
Two-sided market Credit Suisse Crossfinder, Most broker-dealer dark
(dominate in Goldman Sachs Sigma X, pools; may offer some price
terms of ADV) City Match, Baclays LX, discovery and contain
Morgan Stanley MS Pool, proprietary order flow.
UBS PIN
The University of Western Australia 25
Source: https://tabbforum.com/liquidity-matrix/equities/

The University of Western Australia 26

Dark pools – mid-quote execution

 How does it work?

• Derivative pricing rule

 Benefits for venue operators:

• Think of “price matcher” in the context of shopping:
– First, reduce the cost of determining and updating advertised
prices
– Second, in the presence of a price matcher, the “advertiser” has
a reduced incentive to post an aggressive price. When the
“advertiser” lowers the posted price, the additional customers
will be split with the price matcher.

 Impact on the pegged lit venue

• Low or even no volume?
The University of Western Australia 27
Dark pools – dark limit order book market

 How does it work?

• Still kind of derivative pricing rule via complex orders such as
primary-pegged order, mid-pegged order, far-pegged and
near-pegged order.

 Issues:
• Price manipulation
– E.g., I lift up the bid price on the lit venue (so that the
best bid in the dark is lifted) before I sell shares in the
dark venue

The University of Western Australia 28

Dark pools – pros and cons

 Why dark pools have become popular?

• Benefits:
– Cost saving
– Pre-trade opaqueness

• Issues:
– Various pools have various trading rules - complexity;
– More disclosure about their operations are increasingly required by the regulator,
market participants.
– Principal-agent problem
– Institutional brokers who route more orders to affiliated ATS are associated with
lower execution quality (i.e., lower fill rates and higher implementation shortfall
costs).

The University of Western Australia 29

Left: US
Right: Australia

The University of Western Australia 30

Regulations in US

 Volcker Rule
• Part of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.
• Former chairman of the Fed, Paul Volcker
• It prohibits banks and institutions that own a bank from
engaging in proprietary trading or even investing in or
owning a hedge fund or private equity fund.
• Risk concern

 SEC requires ATS to regularly disclose information on

how they operate.
• Principal- agent problem, rule violation et al.

The University of Western Australia 32

Regulations in Europe

 Double Volume Cap (DVC) – part of MiFiD II

• 4% - single venue
• 8% - all venues

 Venues that use periodic auction

• Is it a dark pool?
• Does it result dark execution?
• Recent debate and potential issues

Hans Gulyas, “Periodic auctions under MiFID II a loophole to circumvent

transparency obligations”, Posted on LMS

The University of Western Australia 34

National Best Bid and Offer

 National Best Bid and Offer (NBBO):

• Consolidated Quote System (CQS) consolidates and
broadcasts each market center’s best bid and offer.
• The highest bid at any given time is known as the National
Best Bid (NBB).
• The lowest ask price at any given time is known as the
National Best Offer (NBO).
 NBBO is a regulation by the SEC that requires brokers
to execute customer trades at the best prices available
for buying and selling securities.

The University of Western Australia 35

NBBO
 What is the NBBO at 9:35?
Quotes
Time Bid Offer Exchange
9:31 70.00 70.10 A
9:32 70.05 70.20 B
9:33 69.90 70.15 C
9:34 70.00 70.15 A
• Answer: 70.05 (B) and 70.15 (A,C)
• What about as of time 9:33?
• A similar exercise: Hasbrouck Ex. 5.1

The University of Western Australia 36

Complex orders:
1. Non-displayed orders in lit venue
 Non-displayed orders are limit orders that allow traders
to hide partially or fully the intended volume at the time
of order submission.
• Hidden orders: Min disp. shares (peak size) = 0
• Iceberg orders: Min disp. shares > 0
– only a small part of an order is shown in the limit order
book, while the larger part is hidden.

 They interact with other orders in a limit order market

that also handles visible orders.
– Follow the price-visibility-time priority rule
– Execute in visible markets
The University of Western Australia
 Complex orders:
1. Nondisplayed orders in lit
venue
 How does this type of order work?
• The “price-visibility-time” priority rule is imposed on lit venue.
• Non-displayed shares have lower execution priority over displayed shares.
• Once the peak part is traded, it would be refilled by the remaining volume.

 Example from London Stock Exchange (LSE)

• An iceberg order to buy 25,000 @ 100p with peak = 10,000
(15,000) 10,000 @ 100p

The University of Western Australia 38

Complex orders:
1. Non-displayed orders in lit venue
 Example (cont’d): what if an aggressive sell order of 11,500
shares arrived at 8:26:00?
(5,000) 8,500 @ 100p, new time label 8:26:00

• Transactions (“Time & Sales”) are recorded as:

– 10,000 @100p
– 1,500 @100p

 Anti-gaming feature: Randomize the peak size

• NASDAQ reserve order (also available on LMS as additional reading)
– https://business.nasdaq.com/media/iceberg-order-fs_a4_tcm5044-
59476.pdf

The University of Western Australia 39

Complex orders:
2. Pegged orders
 With a pegged order, the price is set relative to some
other price (typically the NBO, the NBB or the
midpoint).
 If the reference price changes, the order is repriced and
timestamp is updated.

Re-
 For example: Pegged
order
priced
$25.15
arrived
and
2000@ $25.2 priced

1 share@
$25.1

1000@ $25

The University of Western Australia

Complex orders:
2. Pegged orders
 Mid-pegged orders are typically non-displayed.
 Why?
• Once identified, a visible pegged order is an inviting target.
• For example, there is a pegged order to buy 1000 shares at
midpoint. I wish to sell 1000 shares:
– Instead of $25.1, I could raise the NBB and trade against
the pegged order at $25.15.
– Then, cancel my order to buy (1 share @25.1), if possible;
2000@ $25.2
Pegged order to
Pegged order to 1 share@ buy 1000 shr
buy 1000 shr $25.1

1000@ $25

The University of Western Australia 41

 Complex orders:
3. Discretionary orders
 This is basically a limit order, but if the opposing quote
gets within a specified range, the order is repriced to
become marketable.
 For example: a buy limit order 500 @$25, with
discretionary amount of $0.04
Trade at a price no
more than $25.04
2000@ $25.2

20c
-500 4c or less
+500 1000@ $25

Time 1 Time 2
The University of Western Australia 42
Complex orders:
3. Discretionary orders
 So, if you are willing to pay 4c more than the limit price
$25, why not submitting a limit order at $25.04 in the
first place?

Discuss with your neighbour for 2 min….

The University of Western Australia 43

 Complex orders:
3. Discretionary orders
 Example 2: a buy limit order 500 pegged at NBB, with
discretionary amount of $0.04
• The order would be repriced when NBB changes.
• Essentially, compared to a market order, such a limit order
has more control about the price it pays.

-500
2000@ $25.2 4c or less
20c -500
4c or less
+500 1000@ $25

Time 1 Time 2 OR Time 2

The University of Western Australia 44

Last slide

 Lecture quiz
• LMS: Week 3 folder

 Next week
• Information and Price Formation
– What are the different motivations for trading?
– What is the effect of informed trading on prices?
– Information and prices

The University of Western Australia 45