Microstructure of Securities Markets—Trading Systems, Price Discovery, and Determinants of Market Liquidity and Efficiency
tion of liquidity pools between competing markets can make price discovery less efficient and can increase execution costs for large orders.
Trading systems have different levels of transparency; in most major electronic auction markets, there is a depth of transparency for price and volume of pre-trade bids and offers, as well as full post-trade transparency (real time volume and price, and identity of executing dealer). Over-the-counter markets (usually used for less-liquid equity markets, government securities, and corporate debt) would have less transparency, sometimes only post-trading. While transparency is generally encouraged, in some markets it has a reverse effect on liquidity because transparency can drive up impact costs for large trades.16
Trade execution rules include obligations to execute on a particular market or exchange, obligations to get the best price for a customer, and limitations on “internalization” of orders—orders never see the exchange floor but are filled inside the dealer by matching one customer’s order against another. In general, dealers should be required to get the best price for customers, although the best execution rule, as this requirement is called, can arguably interfere with the timely execution of an order. Parochial requirements for execution in a regional market, for example, should not be allowed to inhibit best execution. Internalization of order flow is a controversial issue in most markets—deal – ers and banks will execute client orders either against their own trading books or against each other, rather than exposing the orders to the market. In some markets, internalization can drastically reduce perceived liquidity in the market (because executed trades are not transparent), but there are many arguments that customer orders are more efficiently executed at a fair price when internalized. Policy decisions to prohibit internalization are not necessarily the answer—it is far from clear whether exchanges (particularly as they become privatized) should be afforded a monopoly on liquidity as a matter of policy.
Quality of intermediation—how well dealers, asset managers, and advisers operate—in the market will also affect price discovery and liquidity. Intermediaries should be a reliable source of information (thus reducing asymmetry concerns) through their research function and should, along with a sound payment and settlement system, ameliorate settlement risk. Without a strong research and advisory element in the market place, investors (especially minority investors) will not have sufficient confidence in the accuracy and completeness of disclosure by public issuers. Of course, adequate accounting and auditing standards are the foundation for research, analysis, and disclosure. Without adequate prudential standards, intermediaries will not mitigate settlement risk,17 and weak or absence of prudential standards will damage investor confidence and inhibit liquidity. Lack of prudential standards also may rule out margin lending and securities lending—contributors to liquidity (Group of Thirty, 2003)18—because of the risk involved. Lack of ability to short sell and to invest in derivatives prevents investors and intermediaries from using hedging strategies or acting on all their information,19 and this situation, too, inhibits liquidity. As with rules governing trade execution, regulation of market intermediaries and disclosure regulations should be transparent and predictable in order to attract liquidity (State Street, 2001).
Market integrity (which promotes liquidity) requires entry standards that will protect the market by allowing only “sound” participants; however, unreasonable impediments to entering or exiting the market for either foreign or domestic investors will have a negative impact on liquidity. Transaction, infrastructure, and tax costs will also have an effect on
liquidity. Investors need assurance that holdings can be liquidated when the need arises, without encumbrance or disruption in the market (market failure) and at a reasonable cost. Barriers for cross-border trading, including transaction taxes and reserve requirements, will reduce liquidity. However, once firms are allowed to cross-list on large international markets, trading will be attracted to the larger liquidity pool, leaving smaller, less-developed markets with reduced liquidity.
15. For a description of various microstructure choices see Glen (1994) and Dattels (1997).
16. For an analysis of pre-trade and post-trade transparency, see Ganley, Holland, Saporta, and Vila (1998)
17. By limiting access to the clearing and settlement of trades to properly regulated and well-capitalized intermediaries, the risk that a party to a transaction will default is significantly reduced.
18. The Group of Thirty (2003) advocates removal of tax and regulatory barriers to securities lending. Another barrier may be weak prudential regulation, which creates risks in such activities and causes regulators to disallow lending practices. See also CPSS and Technical Committee of the IOSCO (2001).
19. Selling short provokes strong responses from policy makers. While it should be regulated appropriately, prohibiting short selling will act against liquidity and price discovery. Without the ability to sell short, a trader without a position can only buy and cannot act on information that indicates that price will drop. If a trader cannot act on negative information, the price discovery mechanism will be distorted.
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