FINC3014 Topic 11 Solutions:

Current issues in Trading & Dealing

Question 1
What role do pseudo-informed traders have in the formation of bubbles?
Pseudo-informed traders (traders that react to news when the news is already
impounded in price) are an integral part of the process when a bubble is first created.
Harris (2003) states that bubbles generally start when prices rise on good news about
fundamental values. These initial price changes contribute to fundamental volatility.
Pseudo-informed traders then overreact to the news and add to the resulting price
increases causing prices to eventually exceed fundamental values. This portion of the
bubble contributes to the transitory component of volatility.

Question 2
Do Stop orders mitigate or exacerbate bubbles and crashes? How?
Stop orders exacerbate the existence and extent of both bubbles and crashes. Consider
the case where individuals have stop-loss orders in place to protect them from downward
movements. These orders will be executed automatically upon the reaching of some
share price below the current price. If, as happened during the 2008 financial crisis, bank
stocks experience instability, it is possible for opportunistic short sellers to drive the price
down even further through heavy short selling. As subsequent lower prices are hit, stop-
loss orders begin to automatically trigger, flooding the market with more sell orders,
further depressing share prices and making the crash worse. Similarly, buy orders
executed in a rising market help inflate bubbles even further.

Question 3
To what extent can regulators restrict the trading activities of different market
participants?
It would be very difficult for regulators to design trading restrictions that would
effectively target different types of traders.
Taxes can be used to target the trading of high frequency traders but this may also
impact to a lesser extent all market participants. The introduction of taxes may cause
markets to fragment with trading moving to other exchanges/markets which are not
subject to taxes. In 2013 Italy was the first country to introduce a trading tax specifically
targeted at HFT, charging a levy of 0.02% on equity transactions lasting less than 0.5
seconds.
What will be the effect on the market if trading restrictions are placed on the following
market participants?
1. Informed traders - Make prices less informative
2. News traders - Slow fundamental price changes
3. Value traders - Increase transitory volatility
4. Uninformed traders - Discourage their participation
5. Dealers - Discourage their participation, decrease market liquidity and increase
transitory volatility
Question 4
Hillary Clinton indicated (in 2016) that she would introduce a financial trading tax on high
frequency traders. The proposed tax would have been on cancelled orders only. She said
that high frequency trading "has unnecessarily burdened our markets and enabled unfair
and abusive trading strategies that often capitalize on a 'two-tiered' market structure
with obsolete rules."1 Provide an example of a HFT strategy that may be affected by a
tax on cancelled orders only.
An example is a HFT strategy that intentionally probes the market with tiny orders that
are immediately cancelled, in order to gain a view into the other side's willingness to pay.
If a tiny order is eaten then a new tiny order immediately follows at a higher price. If a
tiny order gets no bite the order is immediately cancelled and a large order to sell is
entered at the highest previously transacted price. As a result the buyer pays a higher
price than it otherwise would.

Question 5
What are crypto-currencies? Do you believe they are here to stay?
Crypto-currencies (e.g. Bitcoin) are digital assets that can be used as an alternative
medium of exchange to government-sponsored fiat currencies. Cypto-currencies are
secured by cryptography and their supply is pre-determined by mathematical algorithms
rather than central banks.

The future of crypto-currencies is unclear. Whether they will become widely accepted
mediums for fulfilling everyday transactions versus being constrained to small niches of
the dark economy is unknowable; this uncertainty has contributed greatly to volatility in
the value of currencies. Crypto-currencies as a whole appear very likely to stay at least
for some transactions (e.g. facilitating illegal money transfers), due to the difficulties of
global regulation.

Whether a specific crypto-currency is here to stay depends on whether its investors and
users can continue to derive a transaction-facilitation advantage from it, whether they
can have faith in rules governing the supply of the currency and in the stability of its
value (e.g. in its exchange rate when converted into US dollars).

1 http://www.cnbc.com/2016/07/22/hillaryclintonsfinancialtransactiontaxwhyitmaynotwork.html
Question 6
What factors cause stock markets to fragment? What factors cause them to consolidate?

Markets fragment due to the differing needs of individual traders. New exchanges can
offer different trading mechanisms (e.g. Iceberg orders, stop orders, etc.) different levels
of information (reveal full limit order book, reveal (or not) broker IDs, reveal (or not) full
size of market order (e.g. dark pools)). Some new markets emerge to offer lower
transaction costs for particular traders. For example, markets who deal in large and small
orders, tend to experience lower adverse selection costs in small orders (who are less
likely to be informed) and these lower costs are used to offset higher adverse selection
costs in large trades. New players can enter the market and cream skim the smaller
orders, offering lower transaction costs due to smaller order sizes.
Markets consolidate due to the network effects of liquidity. Traders who are given the
option of two markets with equal transaction costs will choose the market with the higher
liquidity. This leads to the adage liquidity breeds liquidity. This order-flow externality
tends towards market consolidation rather than fragmentation. This property of
exchanges, a natural monopoly, has allowed the larger exchanges in the US to
consolidate, such that there are currently 3 exchanges, down from 12 in the 1990s.
Systems that automatically route order flow are also very similar between exchanges,
allowing increased cost-synergies should these exchanges be consolidated.

Question 7
Should regulators consolidate all trading to maximize price competition among traders
and to lower liquidity search costs? If so, to what market structure do you think they
should consolidate and why?

If the fragmented markets are sufficiently liquid and different needs of different traders
are satisfied on different platforms the market does not need to consolidate. The linkages
between the platforms need to work to ensure best execution considering all markets.
If markets consolidate they are best off having one consolidated electronic limit order
book for standard trades in liquid securities. Special trading needs can be looked after in
an upstairs market or on a few competing alternative platforms that report their trades
to the consolidated market.

Question 8
What is the difference between Algorithmic Trading and HFT?
Algorithmic Trading refers to the process of using computers to automate trades. This
could be to slice and dice large orders into small packets, distributed across many
alternative trading systems (ATSs) such as Chi-X and ASX.
High Frequency Trading (HFT) is a subset of Algorithmic Trading. High frequency trading
refers to conduct that requires the ability to rapidly cancel or amend trades. These kinds
of activities include market making, following short-term price trends and inter-market
arbitrage.
Question 9
What kind of arbitrage opportunities are created by the following?
1. Multiple Market Places (i.e. ASX and Chi-X).
The existence of multiple marketplaces makes cross-market arbitrage possible.
Imagine there are two markets, Market A and Market B. If there are traders for
security XYZ offering to buy at 1.00 and sell for 1.01 on Market A and I can buy the
same security on Market B for 1.02 and sell for 1.03, a successful strategy will buy
on Market A at the ask of 1.01 and sell on market B at the bid of 1.02, making 1
cent on every share with no risk.
2. Cross-listed securities (i.e. a stock traded in Canada and Australia).
If stocks are cross-listed there should be some relationship between the two. If I can
trade MPO securities in both the ASX and the TSX and both shares represent the
same claims to the firms cash flow, all we need to do is sell the overvalued security,
convert the currency, and buy the undervalued one.
3. Exchange Traded Funds (ETFs) i.e. SPI index trading S&P 200.
If the price of the SPDR S&P/ASX 200 Fund (an ETF, with ticker code STW) and the
ASX SPI 200 futures contract (AP) are not aligned we sell the overvalued security
and buy the undervalued security.
4. The ability to co-locate servers at the exchange.
If you can co-locate servers at the exchange you are able to access the market
quicker than others can. You can now act to trade against any incoming limit order
faster than anyone else. This latency advantage will enable you to high-frequency
market make, follow short-term trends and pick off slow traders.

Question 10
Does HFT improve the efficiency of the marketplace?

HFT can improve efficiency if they are trading on information. Sentiment analysis, for
example, can be used to infer the positive or negative nature of news announcements in
less than a second. If this information is correct, prices will reflect news more quickly,
resulting in increased efficiency. Services such as Alexandria provided by Bloomberg sell
sentiment analysis on news announcements already. If, however, high frequency traders
are trading on short-term trends without any information, they will tend to move prices
away from their fundamental values, reducing efficiency. The impact HFT has on
efficiency will ultimately be determined by the mix of the different strategies that are
being run by market participants, and is an open question for academic research.

Question 11
In the wake of the global financial crisis various commentators have referred to the
collapse as a Minsky Moment, and as the product of Irrational Exuberance. Research and
explain the meaning of these two terms, and apply them to the GFC.

Hyman Minsky was an American economist who specialised in researching financial

crises. He analysed in detail the process through which economies go from stable to
unstable. His basic thesis was that stability leads to excess which leads to crisis. We
could use a banking sector example to show this (which is relevant both to the GFC, the
savings & loans disaster, and to some extent the Great Depression). A period of stability
encourages banks to lower creditworthiness standards and to increase lending quantity
and gearing. This lending leads to an increase in underlying asset prices, which initially
seems to reduce the risk of the financial system. The lending eventually becomes what
Minsky calls Ponzi lending, lending that is unsustainable, requiring ever-rising asset
prices to pay back the principal and interest. Eventually, as the canny investors start to
withdraw capital, the market seizes up, and begins its collapse. The moment in which
investors all start running for the door, all start withdrawing capital en masse, is called
the Minsky Moment. In the GFC there is no clear Minsky Moment, but September 2008 is
a prime candidate (after the collapse of Lehman Brothers).
Robert Shiller recently won the Nobel Prize in Economics. He coined the term irrational
exuberance to refer to an undue level of optimism, felt by investors in a crowd during the
boom phase / bull market phase, before a collapse. Irrational exuberance precedes the
Minsky Moment. Perhaps we can think of 2004-2006 as a period of such exuberance in
the US housing markets.

Question 12
Clearly identify and describe at least three current issues that exist in equity markets
that you believe reduce investor confidence and incentives for investors to trade. Having
identified these issues, outline policies that could be developed to alleviate them.

Note: In addressing this question, please refer to the following speech:

https://www.sec.gov/news/speech/white-equity-market-structure-2016-09-14.html

Strengthening operational integrity

Introduced Regulation CSI to enhance the operational integrity of critical market
infrastructure and reduce the likelihood of technology disruptions (e.g. Nasdaq SIP
outage in 2013 and NYSEs trading outage in 2015).
Enhancements to volatility moderators
The limit-up/limit-down mechanism.
Research to the support of effective arbitrage for ETPs.
Enhancements to transparency
Addressing the evolving transparency gaps between different trading venues e.g.
ATSs and off-exchange trading which can account for more than 30% of trading
volume.
Proposal to require broker-dealers to provide greater disclosure about their order
routing practices.
Consolidated audit trail.
Fairness and efficiency in algorithmic trading
Proposed new rules to enhance record-keeping and related requirements
Follow up on recommendation to run pilot program to lower caps on access fees.
Clarify the status of unregistered active proprietary traders and ensure that all
registered dealers are subject to FINRA oversight.
Address disruptive trading practices that could exasperate price volatility in
vulnerable market conditions.