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How to Open a Financial Market
when Institutional Traders are
Present
Michael S. Pagano
Villanova University
[email protected]
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Is trading this simple? …
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or slightly more difficult ??
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What Motivates Trading?
1. New information (news)
2. Liquidity needs
3. Divergent expectations (people
agree to disagree)
4. Technical (noise) trading
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Fundamental Financing Channels
Firm
Firm
Investor
IB / CB
Buyer
Investor
Seller
Agent
Agent
Exchange
or Market
Maker
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Purposes of Financial Markets
• Set Prices for financial assets
• Exchange Information
• Raise Capital for Issuers (Primary Mkt)
• Liquidity for Investors (Secondary Mkt)
• Vehicle for Managing Risk
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Major Trading Issues
• Liquidity
• Price & Quantity Discovery
• Volatility
• Transaction Costs
• Trading Profits for Market Makers
• Net Investment Returns
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Order Revelation in a Financial Market
“Bookbuilding” is the process of:
– revealing orders and/or trades,
– forming an active market with numerous
traders,
– discovering the asset’s price (price
discovery), and
– deepening the order “book” and/or building
trading volume (quantity discovery).
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Challenges of Order Revelation
• It is not a simple process.
• Existence of an order is information that
can be used against the trader submitting the
order (i.e., it is like a “free” option given to
other traders).
• Adverse price changes can occur due to:
– Market Impact of large orders,
– Front-running, and
– Mis-pricing of early orders.
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Challenges for Large Traders
• Large, institutional traders know that their
actions can impact market prices.
• Large traders are more likely to suffer “ex
post” regret about their trades.
• Therefore, many large traders do not fully
reveal their order sizes, thus creating strong,
latent demand to buy and/or sell.
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A Two-Sided Market with Unequal Orders
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“Most Inefficient” Outcome via Order Shading
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“Most Efficient” Outcome via Open Book
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Building to an Efficient Outcome
with Multiple Orders
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The Iceberg of Transaction Costs
Commission
5 ¢ (17 bp)
Impact
10 ¢ (34 bp)
Delay
23 ¢ (77 bp)
Missed Trades
9 ¢ (29 bp)
Source: Plexus Group, 2003
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Orders Come from 3 Types of Traders
Informed
Liquidity
Order Flow
Technical
Trading
P*
Quotes,
Prices,
Volume
Is p*>offer
or p*<bid?
Do the informed
Traders agree with
each other? maybe not!
Trading Mechanism
Is there a
trend/
pattern?
De-Briefing: P*, Best Bid and Offer
Quotes, and Price Impact
$28.00
$27.00
$26.00
$25.00
$24.00
Ask
$23.00
P*
$22.00
$21.00
Bid
Day 1
Day 2
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Key Questions
• How did you do in terms of achieving your goal? (e.g.,
did you get the shares at a “good” price?)
• What types of orders / trading strategies worked best?
Which worked worst?
• What do you think caused the bid-ask prices to diverge
from the equilibrium P* values?
• Did you shade your orders or did you feel comfortable
submitting large orders?
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