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Part One
Market Microstructure
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Chapter 1
Financial Markets: Traders, Orders, and Systems
This chapter describes a big picture of financial markets: who the traders are, what types of orders can be submitted, how these orders are processed, how prices are formed, and how markets are organized.
Traders
Let us start with the people who trade. They are called (well, you guessed it) traders. Those who trade for their own money (or their employer's money) are proprietary traders. Their ultimate goal is to make profits by buying low and selling high, whether it is long-term investment or day trading. Other traders execute orders for their clients. They are called brokers or agency traders. To denote the institutional character of a broker, the term brokerage (firm) is also used. For brokers, profits from trading may not be important since they receive commissions for trading and other services from their clients. Typical brokerage services include matching the clients' buy and sell orders, connecting to markets, clearing and settlement, providing market data and research, and offering credit. Most of the listed services are self-explanatory, but clearing and settlement may need some elucidation. Settlement is delivery of traded assets to the trading counterparts (buyers and sellers). The trading process (sometimes called the transaction) does not occur instantly. For example, settlement in the spot foreign exchange for most currencies takes two business days. Clearing denotes all brokerage actions that ensure settlement according to the market rules. These include reporting, credit management, tax handling, and so on.
The institutions that trade for investing and asset management (pension funds, mutual funds, money managers, etc.) are called the buy-side. The sell-side provides trading services to the buy-side. Besides brokers, the sell-side includes dealers who buy and sell securities upon their clients' requests. In contrast to brokers, dealers trade for their own accounts. Hence, they have a business model of proprietary traders. Namely, dealers make profits by selling an asset at a price higher than the price at which they simultaneously buy the same asset.1 Providing an option to buy and sell an asset simultaneously, dealers are market makers who supply liquidity to the market (see more about liquidity below). Traders who trade with market makers are sometimes called takers. Many sell-side firms have brokerage services and are called broker-dealers.
Harris (2002) provides a detailed taxonomy of various trader types. Here I offer a somewhat simplified classification. There are two major groups: (1) profit-motivated traders and (2) utilitarian traders. Profit-motivated traders trade only when they rationally expect to profit from trading. Utilitarian traders trade if they expect some additional benefits besides (and sometimes even instead of) profits. Investors who trade for managing their cash flows are the typical example of utilitarian traders. Indeed, when an investor sells (part of) his equity portfolio to get cash for buying a house, or invests part of his income on a periodic schedule, his trades may be not optimal in the eyes of pure profit-motivated traders. Hedgers are another type of utilitarian traders. The goal of hedging is to reduce the risk of owning a risky asset. A typical example is buying put options for hedging equities. Put options allow the investor to sell stocks at a fixed price.2 The immediate expenses of buying options may be perceived as a loss. Yet these expenses can protect the investor from much higher losses in case of falling stock price. In the economic literature, utilitarian traders are often called liquidity traders to emphasize that they consume the liquidity that is provided by market makers.
Profit-motivated traders can be partitioned into informed traders, technical traders, and dealers.3 Informed traders base their trading decisions on information on the asset fundamental value. They buy an asset if they believe it is underpriced in respect to the fundamental value and sell if the asset is overpriced. Since buying/selling pressure causes prices to increase/decrease, informed traders move the asset price toward its fundamental value. Traders who conduct thorough fundamental analysis of the asset values, such as the company's profits, cash flow, and so on, are called value investors (Graham & Dodd 2006). Note that fundamental values do not always tell the entire story. New information that comes in the form of unexpected news (e.g., discovery of a new technology, introducing a new product by a competitor, CEO resignation, or a serious accident, etc.) can abruptly challenge the asset price expectations. Also, estimates of the fundamental value of an asset may vary across different markets. Traders who explore these differences are called arbitrageurs (see Chapter 11).
Technical traders believe that the information necessary for trading decisions is incorporated into price dynamics. Namely, technical traders use multiple patterns described for historical market data for forecasting future price direction (see Chapter 10).
As it was indicated above, dealers (market makers) supply liquidity to other traders. In some markets, traders who are registered as dealers receive various privileges, such as exclusive handling of particular securities, lower market access fees, and so on. In return, dealers are required to always provide at least a minimum number of securities (in which they make the market) for buying and selling. Dealers make profits from the difference between the selling price and buying price that they establish. This implies that there are takers in the market who are willing to buy a security at a price higher than the price at which they can immediately sell this security. It seems like easy money providing that the price does not change and there are equal flows of buying and selling orders. Obviously, there is always a risk that dealers have to replenish their inventory by buying security at a price higher than the price they sold this security in the near past. This may be caused by a sudden spike in demand caused by either informed or liquidity traders. Similarly, dealers' loss may ensue when takers exert selling pressure. We shall return to the dealers' costs in Chapters 3 and 4.
Orders
When traders decide to make a trade, they submit orders to their brokers. Order specifies the trading instrument, its quantity (size), market side (buy or sell), price, and some other conditions (if any) that must be met for conducting...
