FE570 Market Microstructure and Trading Strategies

Lecture 1. Introduction

Dan Pirjol

Stevens Institute of Technology

Week 1

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Outline

Logistics

Course Project

A Brief History of the Modern Market

Markets with market makers
Electronic markets
Hybrid markets

What is Market Microstructure?

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▶ Instructor: Dan Pirjol, Babbio 303C, [email protected]

▶ Class Time (Section A): Monday 6:30-9:00PM

▶ Location: Babbio room 320
▶ WebCampus (Section WS): Lectures will be taught synchronously
on Monday 6:30-9:00 PM and the recordings will be available on
Canvas.

▶ Office Hours: Monday 2:00PM-3:00PM

▶ Prerequisites: Basic concepts of markets and financial products.
Some knowledge of statistics and probability - popular distributions
and some time series analysis. Some programming knowledge (R,
Python), R preferred. The course will use R.

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Policies

Attendance (Section A): Attendance is mandatory. At most one

unexcused absence per semester. The Class participation grade includes an
attendance component
Number of attended classes
100 ×
Number of total classes
Zoom attendance does not count
Attendance (Section WS): Attendance is not required.

Homework guidance: Assignments which require coding must be

submitted as R MarkDown pdf file. The file must contain explanations:
how does the output answer the question asked. Just submitting the code
with output (even if correct) without any comments will not get the full
grade.

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Exams & Grades

Grades: Class Participation - 10%; Homework Assignments - 30%;

Mid-term - 30%; Project - 30%.

Exam: Mid-term: Oct 28th - (Monday). The exam will consist of short
theory questions, and data analysis using R or Excel.

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Course Project

Team based project: you will form teams of 3-4 students and work together
on the project. Each team will give a 15-20 min presentation, during the last
week.

Several types of projects are possible:

i) implement a model discussed in class and run simulations. For example:
Limit Order Book simulation, Kyle model for strategic trading,
Glosten-Milgrom.
ii) analyze a tick level dataset by applying the methods learned in class -
study liquidity, volatility, informed trading, based on data.
iii) implement a trading strategy in SHIFT

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Topics

▶ The first part of the course offers an overview of the markets

structures (dealer markets, auction and continuous time
double-auction markets), market participants, orders, and the
stylized facts of the financial markets.

▶ The second part of the course covers several market microstructure

models used to describe price formation and the main features of the
financial markets at microscale: Roll model, zero intelligence models,
information-based models and models of limit-order book markets.

Students are required to learn the basics of R statistical computing

language, and use it to analyze microstructure data.

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▶ Learning Outcomes:
After successful completion of this course, students will be able
to:
1. Understand the fundamental ideas behind various financial market
architecture and designs.

2. Understand important market structure theories in terms of return,

volatility, liquidity, etc.

3. Understand the major market regulation frameworks for equity trading in

the US (Reg NMS)

4. Understand the classical microstructure models and how they explain the
stylized features of the markets at microscale.

5. Able to use R language to analyze the market data.

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▶ Textbooks:
▶ Joel Hasbrouck, Empirical Market Microstructure, Oxford University Press,
2007
▶ Larry Harris, Trading and Exchanges: Market Microstructure for
Practitioners, Oxford University Press, 2002
▶ Anatoly B. Schmidt, Financial Markets and Trading: An Introduction to
Market Microstructure and Trading Strategies, John Wiley & Sons, Inc.,
Hoboken, New Jersey.
▶ T. Foucault, M. Pagano and A. Röell, Market Liquidity: Theory, Evidence
and Policy, Oxford University Press

You will be learning R Statistical Package throughout the course. Easy to

use - some guidance can be found in the Canvas shell of the course.

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Course outline

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ChatGPT

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ChatGPT

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ChatGPT

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Short history of markets and exchanges

▶ 1460: the Bourse of Antwerp opens - world’s first commodity

exchange. Followed in 1565 by the Royal Exchange, London.
▶ 1611: The first stock trading exchange is created in
Amsterdam. The Dutch East India Company is the first
publicly traded company, and for many years, it is the only
company traded on the exchange.
▶ 1792: A small group of merchants sign the Buttonwood Tree
Agreement. This is the starting agreement of the New York
Stock Exchange.
▶ 1790: The Philadelphia Stock Exchange is formed, helping
spur the development of the U.S. financial sector and the
country’s expansion west.
▶ 1971: Trading begins on NASDAQ, the National Association
of Securities Dealers Automated Quotations.

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New York Stock Exchange

Figure: Buttonwood Agreement: ”We the Subscribers, Brokers for the Purchase and
Sale of Public Stock, do hereby solemnly promise and pledge ourselves to each other,
that we will not buy or sell from this day, any kind of Public Stock, at a less rate than
one quarter per cent Commission and that we will give a preference to each other in
our negociations.” New York, 17 May 1792.

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Market

A market is a mechanism for connecting buyers and sellers.

Must resolve the opposite wishes of the market participants:

▶ buyers want to buy low
▶ sellers want to sell high

Requirements:
▶ Market stability
▶ Fair and orderly trading

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Market

Historically, financial markets employed market makers

(specialists). Their roles are:
▶ Quoting. At all times, market makers must provide bid/ask
prices. These quotes are binding.
▶ Clearing. Once buyers and sellers have submitted orders at
given prices and volumes, the market maker decides on a
transaction price. In a given transactions, orders at cleared at
this price.

In this model there are two types of traders:

▶ Market-makers. Liquidity providers.
▶ Other traders. Liquidity takers.

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Electronic markets

Modern financial markets (mostly) eliminated the market-makers.

Market participants trade directly. The mechanism is called
continuous-time double auction.
▶ Buyers and sellers submit limit orders: commitments to
buy/sell at certain prices. This information is available to all
market participants as the Limit Order Book (LOB)
▶ A transaction will occur whenever a buyer and seller agree on a
price.
▶ Buyers/sellers can submit also market orders. Such orders will
be executed immediately at the best available price.
Orders are transmitted electronically and are placed in a queue, to
be executed in a specified priority order.

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Specialists and DMM

There is still a place for specialists and designated market makers

(DMM). They participate in the opening and closing auctions on
exchanges (NYSE) and step in to make quotes in turbulent
markets.

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Market Fragmentation

Traditionally the market structure was 3-layered with a few

exchanges
▶ Investors
▶ Intermediaries (brokers)
▶ Market operators (exchanges), e.g. NYSE, Nasdaq, BATS

Modern equity markets are very fragmented. There are about 20

exchanges in the US, and many more abroad. There are also
Alternative Trading Venues such as dark pools, Electronic Crossing
Networks, Multilateral Trading Facilities.

Regulation has been introduced to ensure the orderly and fair

functioning of these markets: Reg NMR (US) and MiFID (Europe).

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What is Market Microstructure?

In Market Microstructure we study the plumbing of the financial

markets:
1. How do markets begin/end trading each day?
2. How do buyers and sellers come to agree on a price?
3. What is liquidity and how do we measure it?
In the world of market microstructure, alpha is allowed. Markets
are not always efficient.

Microstructure effects are small, but became important with the

advent of electronic trading: the huge amount of trades produced
massive amounts of data, which became available for study. These
effects may amount to fractions of pennies per trade, but with
millions of trades per second they add up.

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What is not Market Microstructure?

In the world of Market Microstructure, the Efficient Markets

Hypothesis does not apply.

If you believe that markets are efficient then:

▶ The details of trade execution do not matter.
▶ You always get the efficient price

These statements are true only up to market microstructure effects!

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Questions addressed by Market Microstructure theory

▶ Who are the players of the market?

▶ What are the key components of the markets?

▶ What are the rules people have to follow?

▶ What information do you need to know before you can make a trade?

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