Market Microstructure. (Conferences).

The NBER's Working Group on Market Microstructure met in Cambridge on December 6. Bruce Lehmann, NBER and University of California, San Diego; Andrew Lo, NBER and MIT; Matthew Spiegel, Yale University; and Avanidhar Subrahmanyam, University of California, Los Angeles, organized this program:

Bruno Biais and Christophe Bisiere, Toulouse University, and Chester S. Spatt, Carnegie Mellon University, "Imperfect Competition in financial Markets: ISLAND vs. NASDAQ"

Discussant: Stewart Mayhew, University of Georgia 

Sugato Chakravarty, Purdue University; Venkatesh Panchapagesan, Washington University; and Memphis, "Has Decimalization Hurt Institutional Investors? An Investigation into Trading Costs and Order Institutions"

Discussant: Tarun Chordia, Emory University

Kee H. Chung, SUNY; Chairat Chuwonganant, Purdue University; and D. Timothy McCormick, NASDAQ, "Order Preferencing and Market Quality on NASDAQ Before and After Decimalization"

Discussant: Michael Barclay, NBER and University of Rochester 

Burton Hollifield and Robert A. Miller, Carnegie Mellon University; Patrik Sandas, University of Pennsylvania, and Joshua Slive, HEC Montreal, "Liquidity Supply and Demand in Limit Order Markets"

Discussant: Ohad Kadan, Washington University

Magueye Dia, Oxford University and Sebastian Pouget, Georgia State University, "Sunshine Trading in West Africa: Liquidity and Price Formation of Infrequently Traded Stocks"

Discussant: Barbara Ostdiek, Rice University

The Internet technology reduces the cost of transmitting and exchanging information. Electronic Communications Networks (ECNs) -- including Island, Archipelago, and Redi -- exploit this opportunity; enabling investors to place quotes at very little cost, and compete with incumbent stock exchanges. Does this quasi-free entry situation lead to competitive liquidity supply? Biais, Bisiere, and Spatt analyze trades and order book dynamics on the Nasdaq and Island. The Nasdaq Touch -- the best price quote available through the NASDAQ market makers' network for a given security at a point in time -- frequently is undercut by Island limit orders, using the finer tick size prevailing on that ECN. Before decimalizaton, the coarse tick size constrained Nasdaq spreads, and undercutting Island limit order traders earned oligopoly rents. After decimalization, the hypothesis that liquidity suppliers do not earn rents cannot be rejected.

Chakravarty, Panchapagesan, and Wood examine the effect of decimalization on institutional investors. Using proprietary data, they find that decimalization has not increased trading costs for institutions. In fact, they find an average decrease of 13 basis points, or roughly $224 million a month, in savings of institutional trading costs after moving to decimal trading. As to institutional order-routing practices, the smaller and easier-to-fill orders more often are routed to electronic brokers, while the larger and more-difficult-to-fill orders are sent to traditional brokers. The trading costs of orders routed to electronic and independent research brokers increase, while the costs of trading with full service and soft dollar brokers go down. Interestingly, the authors find less usage of soft dollar brokers, suggesting that decimalization may have altered the incentives of this multi-billion dollar industry. These results survive extensive partitioning of the data and differ in spirit from those reported ar ound the transition of the minimum tick size from eighths to sixteenths. The results are also surprising in light of an oft-repeated complaint among professional traders: that liquidity is hard and expensive to find in a post-decimal trading milieu.

No hard evidence exists on the extent and determinants of order preferencing and its impact on dealer competition and execution quality. Chung, Chuwonganant, and McCormick show that the bid-ask spread (dealer quote aggressiveness) is positively (negatively) related to the proportion of internalized trades during both the pre- and post- decimalization periods. Although decimal pricing led to lower order preferencing on NASDAQ, the proportion of preferenced trades after decimalization is much higher than what some prior studies had predicted. The authors find that the price impact of preferenced trades is smaller than that of unpreferenced trades and that preferenced orders receive greater (smaller) size (price) improvements than unpreferenced trades.

Hollifield, Miller, Sandas, and Slive model a trader's decision to supply liquidity by submitting limit orders, or demand liquidity by submitting market orders, in a limit-order market. The best quotes and the execution probabilities and picking-off risks of limit orders determine the price of immediacy. The price of immediacy and the trader's willingness to pay for it determine the trader's optimal order submission; the trader's willingness to pay for immediacy depends on the trader's valuation for the stock. The authors estimate the execution probabilities and the picking-off risks using a sample from the Vancouver Stock Exchange to compute the price of immediacy. The price of immediacy changes with market conditions -- a trader's optimal order submission changes with market conditions. The authors combine the price of immediacy with the actual order submissions to estimate the unobserved arrival rates of traders and the distribution of the traders' valuations. High realized stock volatility increases the a rrival rate of traders and increases the number of value traders arriving -- liquidity supply is more competitive after periods of high volatility. An increase in the spread decreases the arrival rate of traders and decreases the number of value traders arriving -- liquidity supply is less competitive when the spread widens.

Dia and Pouget study liquidity and price formation in the West-African Bourse. They provide evidence consistent with investors using the preopening period to implement sunshine trading, and prices revealing information before trading actually occurs. They argue that market participants implement order-placement strategies bound to enhance market liquidity. They also underline the role of the preopening period as a powerful tool for disseminating information regarding both liquidity needs and stock valuation. The authors interpret the empirical results in the framework of a simple theoretical model. For some parameters' value, at equilibrium, market non-anonymity and repeated interaction enable investors to coordinate on trading strategies, improving market quality as it is observed in the West-African Bourse. These findings have implications for global portfolio management and for the design of financial markets.