LOBSTER June 2nd 2016

Algorithmic and High-Frequency Trading

A Primer on the Microstructure of Financial Markets

Julia Schmidt
 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Introduction

Market Microstructure
— subfield of finance
— “study of the process and outcome of exchanging assets under explicit
trading rules” (O’Hara(1995))
Key Dimension of trading and pricing: Information
Price Efficiency
— “market prices are an efficient way of transmitting the information
required to arrive at a Pareto optimal allocation of resources”
(Grossman&Stiglitz (1976))
Trading: many possible ways
— focus on trading in large electronic markets

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Market Making

Market participants
— Market Maker (MM)
— Liquidity Trader (LT)
Market Maker
— Competition
— Provide liquidity immediacy
— Bid and ask prices Limit Orders
Liquidity Trader
— Take liquidity

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model

Providing liquidity accept one side of trade hold assets until person with
matching demand enters market risk of prices moving against MM
Risk Premium/Liquidity Premium
Model
— n identical Market Makers
— three dates 𝑡 ∈ {1,2,3}
— no uncertainty about arrival of matching orders

1 2 3
t
LT1 wants to sell i LT2 wants to buy i
units of the asset units of the asset

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units

Beginning (t=0)
— W0 : initial cash amount
— MM: no assets
— LT1: i units
— LT2: -i units
No trading or direct costs for holding inventory

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units

St : cash value of asset in t

𝑆3 = 𝜇 + 𝜖2 + 𝜖3
— 𝜇: constant
— 𝜖2 and 𝜖3 : independent, 𝑁(0, 𝜎 2 ), random variables
— 𝜖2 : announced between t=1 and t=2
— 𝜖3 : announced between t=2 and t=3

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units

Risk averse participants

— Expected utility: 𝐸 𝑈 𝑋3 where U X = −exp(−𝛾𝑋)
— 𝛾: utility penalty for taking risk risk aversion parameter

𝑗
𝑞𝑡 : asset holdings at the end of period t
𝑗 ∈ {𝑀𝑀, 𝐿𝑇1, 𝐿𝑇2}

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units
t=3
𝑆3 = 𝜇 + 𝜖2 + 𝜖3
t=2
𝑗 𝑗 𝑗 𝑗 𝑗 𝑗 𝑗 𝑗
max
𝑗
𝔼 𝑈 𝑋3 |𝜖2 s.t. 𝑋3 = 𝑋2 + 𝑞2 𝑆3 and 𝑋2 + 𝑞2 𝑆2 = 𝑋1 + 𝑞1 𝑆2
𝑞2

𝑗,∗ 𝔼 𝑆3 𝜖2 ]−𝑆2
𝑞2 = 𝛾𝜎 2
∀𝑗

equal demand and supply in t=2, i assets are hold by MM & LT1, 𝑞1𝐿𝑇2 = −𝑖
𝑗,∗
𝑞2 = 0, 𝑆2 = 𝜇 + 𝜖2

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units
t=1 (X3=X2)
𝑗 𝑗 𝑗 𝑗 𝑗 𝑗 𝑗 𝑗
max 𝔼 𝑈 𝑋2 s. t. 𝑋2 = 𝑋1 + 𝑞1 𝑆1 and 𝑋1 + 𝑞1 𝑆1 = 𝑋0 + 𝑞0 𝑆0
𝑗
𝑞1

𝑗,∗ 𝔼[𝑆2 ]−𝑆1

𝑞1 = 𝛾𝜎2
for MMs and LT1

equal demand and supply in t=1 and 𝑞0𝑀𝑀 = 0

𝑗,∗ 𝑖 𝑖
𝑞1 = and 𝑆1 = 𝜇 − 𝛾𝜎 2
𝑛+1 𝑛+1

A Primer on the Microstructure of Financial Markets

 Grossman-Miller Market Making Model
1 2 3
t
LT1 : sell i units LT2 : buy i units

Influence Factors on Risk Premium

— size of the liquidity demand |i|
— amount of competition between MMs n
— market risk aversion 𝛾
— volatility of the underlying asset 𝜎 2
𝑛 → ∞ Liquidity Premium goes to zero
Price converges to efficient level 𝑆1 = 𝜇
LT1 net trade converges to liquidity need

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Trading Costs

Model with participation costs c

— c : proxy for time and investments needed to keep a constant, active and
competitive presence in the market + opportunity costs
— Result:
Level of competition decreases monotonically with supplier’s
participation costs
Increase the liquidity premium

A Primer on the Microstructure of Financial Markets

 Trading Costs

Model with trading cost 𝜂

— Depend on level of activity in the market (proportional to shares traded)
— Act like participation costs for liquidity traders (fees are known)
Relatively small trades are too expensive
t=2
𝑗,∗ 𝔼 𝑆3 −𝜂 𝜖2 ]−(𝑆2 −𝜂)
𝑞2 = for LT1 & MM
𝛾𝜎 2

𝔼 𝑆3 +𝜂 𝜖2 ]−(𝑆2 +𝜂)
𝑞2𝐿𝑇2,∗ = 𝛾𝜎 2

𝑆2 = 𝜇 + 𝜖2 ,

A Primer on the Microstructure of Financial Markets

 Trading Costs

t=1
— LT1: any quantities he doesn’t sell now he has to sell later
𝔼 𝑆2 −𝜂 𝜖2 ]−(𝑆1 −𝜂)
𝑞1𝐿𝑇1 = 𝛾𝜎2
— MM: whatever they buy they have to sell later
𝔼 𝑆2 −𝜂 𝜖2 ]−(𝑆1 +𝜂)
𝑞1𝑀𝑀 = 𝛾𝜎 2
— Equal demand and supply in t=1
𝑆1 = 𝜇 − 𝛾𝜎 2 𝑛+1
𝑖 𝑛
− 2𝑛+1 𝜂 and 𝑞1𝐿𝑇1,∗ = 𝑖
𝑛+1
𝑛
+ 2 𝑛+1 𝜂
𝛾𝜎2
Extra liquidity discount
Almost all trading fees are paid by the LT initiating the transaction
Increase in trading fees has smaller effect via competition but greater effect
on immediacy and the liquidity discount than participation costs

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Measuring Liquidity

Transformation to electronic asset markets

— Trading does not take place at once and not to a single price
— LT post MO into exchange meet LO of MM, which are resting in LOB
— Here:
LT1’s MO enters market and is executed against LO in LOB
Possibilities: one large order or many small orders
As execution price changes, so does LT1’s strategy and eventually, after
𝑛
selling 𝑖 𝑛+1 shares, the price has moved too far and LT1 stops trading
Overall: execution at average price S1
Risk premium: S1 – midprice of first MO

A Primer on the Microstructure of Financial Markets

 Measuring Liquidity

Effect of traded quantity Rewrite S1

𝑆1 = 𝜇 + 𝜆𝑞 𝐿𝑇1
Grossman-Miller model:
1 𝑛
𝜆 = − 𝛾𝜎 2 and 𝑞 𝐿𝑇1 = 𝑖
𝑛 𝑛+1
— 𝜆 : market price reaction to LT1’s total order (price impact)
— Describes liquidity of the market for this asset
— The more liquid, the lower the absolute lambda

A Primer on the Microstructure of Financial Markets

 Measuring Liquidity

Other way to measure liquidity: autocovariance in asset price changes (or returns)
Introduce new date t=0 and a random public event 𝜖1 announced between 0 and 1
— 𝑆3 = 𝜇 + 𝜖1 + 𝜖2 + 𝜖3
— 𝜇0 = 𝔼 𝑆3 , 𝜇1 = 𝔼 𝑆3 𝜖1 , 𝜇2 = 𝔼 𝑆3 𝜖1 , 𝜖2 , 𝜇3 = 𝑆3
— 𝜖1 , 𝜖2 , 𝜖3 i.i.d. ~𝑁(0, 𝜎 2 )
— Discrete process 𝜇𝑡 is a martingale, efficient price process
— No trades in t=0 𝑆0 = 𝔼 𝑆3 = 𝜇0
— 𝑆1 = 𝜇 + 𝜆𝑞 𝐿𝑇1 , 𝑆2 = 𝜇2
— Δ1 = 𝑆1 − 𝑆0 , Δ2 = 𝑆2 − 𝑆1
𝐶𝑜𝑣 Δ1 , Δ2 = −𝜆2 𝑉𝑎𝑟 𝑞 𝐿𝑇1 < 0
Autocovariance captures liquidity just like price impact does
𝜆 → 0 𝐶𝑜𝑣 → 0 price process converges to martingale process 𝜇𝑡

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Market Making using Limit Orders

Small risk-neutral trader with costless inventory management and infinite patience
Other MMs do not react to our MMs decision
Don‘t know time and size of incoming MOs
𝑆𝑡 : current value of asset, midprice
Liquidates her inventory at midprice at no costs

𝛿 ± : depth, distance from mid price

𝑝± : probability that an MO arrives
𝑃± : cdf, probability that price walks to MM‘s LO after arrival of MO
𝑝− 𝑃− (𝛿 − ): prob that buy LO is filled
Distribution of other− LO’s: exponential with parameter 𝜅 ±
−
𝑝− 𝑃− (𝛿 − ) = 𝑝− 𝑒 −𝜅 𝛿

A Primer on the Microstructure of Financial Markets

 Market Making using Limit Orders

Π: MM‘s profit per trade

+𝛿+ −𝛿−
max
+ −
𝔼[Π (𝛿 + , 𝛿 − )] = max
+ −
{𝑝+ 𝑒 −𝜅 𝛿 + + 𝑝− 𝑒 −𝜅 𝛿 −}
𝛿 ,𝛿 𝛿 ,𝛿

1
𝛿 ±,∗ = 𝜅±

Given our parametric choice of 𝑃± , the optimal depth is equal to the mean depth
in the LOB

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Trading on an Informational Advantage

Market for an asset, opens only at one time point

S: trading price S v
v: future cash value after trading ~𝑁 𝜇, 𝜎 2
t
Traders:
— Informed trader: knows exact value of v
— Anonymous mass of price insensitive liquidity traders (LT)
— Large number of MMs (observe and compete for order flow)
Risk neutral do not need a liquidity premium for taking risk
Liquidity premium from informational disadvantage (will be borne by LTs)
Know that there is one informed trader, don’t know who it is
u: net demand of LTs ~𝑁 0, 𝜎𝑢2 independent of v
x(v): number of shares traded by the informed trader
x(v) + u : net order flow observed by MMs
A Primer on the Microstructure of Financial Markets
 Trading on an Informational Advantage

Solution: Bayesian Nash equilibrium

— All agents optimize given the decisions of all other players according to their
beliefs
𝑆 = 𝔼 𝑣 ℱ where ℱ:all information available to MMs (semi-strong efficiency)
𝑆 𝑥+𝑢 =𝔼 𝑣 𝑥+𝑢
— Because of the normality of 𝑣 and u insiders hypothesize
𝑆 𝑥 + 𝑢 = 𝜇 + 𝜆(𝑥 + 𝑢)
— 𝜆: linear sensitivity of the market price to order flow
max 𝔼[𝑥 𝑣 − 𝑆 𝑥 + 𝑢 ] 𝑥 ∗ 𝑣 = 𝛽 𝑣 − 𝜇 ; 𝛽 = 2𝜆 −1
𝑥
2 𝑥+𝑢 𝜎𝑢 2𝜎𝑢
𝑆 = 𝔼[𝑣|𝑥 + 𝑢] = 𝜇 + premium (𝜆 = )
𝜎 𝜎

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 MM with an Informational Disadvantage

Many informed traders, can only trade 1 unit

Nature
𝑝 1−𝑝

𝑉𝐻 𝑉𝐿

𝛼 1−𝛼 𝛼 1−𝛼

Informed Uninformed Informed Uninformed

1/2 1/2 1/2 1/2

Buy (a) Buy (a) Sell (b) Sell (b) Sell (b) Buy (a)

A Primer on the Microstructure of Financial Markets

 MM with an Informational Disadvantage

Δ𝑎 , Δ𝑏 : ask- and bid-halfspreads 𝑠𝑝𝑟𝑒𝑎𝑑 = Δ𝑎 + Δ𝑏

MM chooses 𝑎 = 𝜇 + Δ𝑎 and 𝑏 = 𝜇 − Δ𝑏 (𝜇 = 𝔼[𝑣|ℱ])
Buy order comes in:
— From uninformed LT expected profit 𝑎 − 𝜇 = Δ𝑎
— From informed Trader expected loss 𝑎 − 𝑉𝐻 = Δ𝑎 − 𝑉ℎ − 𝜇
Expected profit of posting price a:
(1−𝛼)/2 𝛼𝑝 !
Δ + Δ𝑎 − 𝑉𝐻 − 𝜇 = 0
𝛼𝑝+(1−𝛼)/2 𝑎 1−𝛼
𝛼𝑝+ 2

1 1
Δ𝑎 = 1−𝛼 1/2 (𝑉𝐻 − 𝜇) Δ𝑏 = 1−𝛼 1/2 (𝜇 − 𝑉𝐿 )
1+ 𝛼 1+ 𝛼 1−𝑝
𝑝

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Price Dynamics

Incorporate time dimension, for simplicity: interest = zero

Determination of cash value at t=T
ℱ𝑡 : Public information in t
𝑝𝑡 = ℙ 𝑣 = 𝑉𝐻 ℱ𝑡 , 𝜇𝑡 = 𝔼 𝑣 ℱ𝑡
1
𝑎𝑡 = 𝜇𝑡 + Δ𝑎,𝑡 = 𝜇𝑡 + 1−𝛼 1/2 (𝑉𝐻 − 𝜇𝑡 )
1+ 𝛼 𝑝
𝑡
1
𝑏𝑡 = 𝜇𝑡 + Δ𝑏,𝑡 = 𝜇𝑡 − 1−𝛼 1/2 (𝜇𝑡 − 𝑉𝐿 )
1+ 𝛼 1−𝑝
𝑡
At every execution, the execution price is equal to the expectation of the
underlying asset conditional on the history of order flow and also on the
information in the execution (buy or sell) realized price process is a martingale

A Primer on the Microstructure of Financial Markets

 Overview

Introduction
Market Making
— Grossman-Miller Market Making Model
— Trading Costs
— Measuring Liquidity
— Market Making using Limit Orders
Trading on an Informational Advantage
MM with an Informational Disadvantage
— Price Dynamics
— Price Sensitive Liquidity Traders

A Primer on the Microstructure of Financial Markets

 Price Sensitive Liquidity Traders

LTs avoid trading if the half-spread is too high

𝐿𝑇𝑖 gets a cash equivalent utility gain of 𝑐𝑖 (urgency parameter) if he executes his
desired trade if 𝑐𝑖 < Δ the trade won’t be executed
𝐹 𝑐 = ℙ(𝑐𝑖 < 𝑐)

1 1
Δ𝑎 = 1−𝐹 Δ𝑎 𝑉𝐻 − 𝜇 Δ𝑏 = 1−𝐹 Δ𝑏
𝜇 − 𝑉𝐿
1−𝛼 2 1−𝛼
1+ 1+ 2
𝛼 𝑝 𝛼 𝑝

MM increases halfspread smaller population of LTs trades

𝑐𝑖 small Δ𝑎 = 𝑉𝐻 − 𝜇 and Δ𝑏 = 𝜇 − 𝑉𝐿 = solution without LTs market collapse
strong efficient price

A Primer on the Microstructure of Financial Markets

 Thank you

A Primer on the Microstructure of Financial Markets