Part 3: Endogenous order choice; chapter 8: Order -
driven markets
1. Introducti on
-> After having discussed dealer markets (Part 2), we now turn to limit order markets (LOM, also
called order-driven markets)
-> Almost all large stock exchanges are order driven or have an important order-driven element in
their design
-> Euronext, Tokyo Stock Exchange
-> NYSE: dealer competes with limit order book (LOB)
-> Some alternative trading systems (i.e. ECNs, see Part 4) function essentially as anonymous
limit order books
-> Also other securities trade in electronic limit order markets (or at least allow for customer limit
orders in addition to on-exchange marketmaking)
-> example: Liffe (derivatives), MTS (bonds)
-> limit order book introduced in FOREX market
-> A detailed discussion by means of an example of the functioning of limit order markets will be
given in the next section
-> the order book has a small-trade positive bid-ask spread, and limit orders profit from small
trades
-> the electronic exchange provides as much liquidity as possible in extreme situations
-> the limit order book does not invite competition from third market dealers, while other
trading institutions do
-> if an entering exchange earns nonnegative trading profits, the consolidated price
schedule matches the limit order book price schedule
-> Suppose a trader submits a limit order to sell
-> Can’t we see this as something very similar to a quote of a dealer, but just having another
name?
-> No! We miss an important element since the perspective is different
-> in a dealer market there is a sharp distinction between liquidity suppliers and demanders
-> in a LOM this distinction becomes blurred I As we will see, agents choose dynamically
whether they want to supply liquidity (submit a limit order), or demand liquidity (by using
a market order)
-> So, order choice will be a main topic in this part on LOMs!
1
H8
,-> There are no dealers with an obligation to post quotes
-> Trading is directly between traders
-> Traders have to choose between submitting a limit order (LO) and a market order (MO)
-> we ignore other order types
-> marketable limit orders are considered to be market orders
-> LO are stored in the limit order book for possible future execution against incoming
MO
-> MO are said to demand liquidity from the market
-> LO are said to supply liquidity to the market
2. Example: conti nues order-driven market
-> Assumptions
-> We start with an empty limit order book (LOB)
-> tick size (minimum price variation) is e 0.1 (Note that e.g. on Euronext this is much smaller (as
small as 0.005 or 0.001 euro)).
-> We now look at how the LOB is affected by a number of incoming orders
-> Limit order to sell with price $10.2 (or better) and quantity 100 (price and quantity = limit order)
-> Limit order to buy with price $10.0 (or better) and quantity 150
-> Best ask = $10.2
-> Price at which a next trader can buy (but results from limit sell!!)
-> Best bid = $10.0
-> Price at which a next trader can sell (but results from limit buy!!)
-> Bid-ask (inside) spread = $0.2 = 2 ticks
-> Depth at best ask is 100 shares, depth at bid side is 150
-> Limit order to sell with price $10.3 and quantity 50
-> Limit order to sell with price $10.6 and quantity 250
-> Limit order to buy with price $0.99 and quantity 175
(Note: the trader makes a typo in the order!)
-> Not all markets check for these typo’s
-> We now have limit order book
-> How are new incoming orders matched with the LOB? In particular, how is determined which
orders in the LOB are executed against the incoming order
-> 2 main rules are generally applied = order precedence rules
1) price priority : orders with a better price are executed first
2) time priority : when orders have the same price, an order that was submitted earlier is
executed first
2
H8
,-> Market order to buy 50 shares (you don’t specify a price, so it’s a market order)
-> this order is executed at the best price possible in the market, i.e. the best ask
-> depth at the best ask decreases with 50
-> When there are 2 market orders, then we look at the time priority
-> Time priority is always secondary to price priority
-> Assume you submit a (pure) market order to sell 280 shares
-> this order is executed at the best price possible in the market, i.e. the best bid
-> but depth at best bid is only 150 → 150 shares are sold at e 10.0
-> rest of the order is executed at the second best bid → 150 shares are sold at e 0.99!!!
-> Market orders without price limit are dangerous!
-> Order that walks the book
-> when 1 bid price doesn’t have enough shares, then you automatedly go to the
next price
-> Other example
-> Limit order to buy 50 shares at a limit price of $10.3
-> Best ask in market is $10.2
-> LO says: buy at $10.3 or better, so the order is executed at the best ask
-> this is a marketable limit order = a limit order that can be executed immediately
-> As if it is a market order, but with a limit, so it prevents it to walk the book to far
-> Limit order to buy 50 shares at a limit price of $10.1
-> best ask in market is $10.2
-> LO says: buy at $10.1 or better, so the order cannot be executed
-> it is recorded in the book
-> the best bid is improved (undercutting), the spread narrows
3
H8
, -> Steal order: that are old orders that haven’t been cancelled yet
-> Limit order to sell 100 shares at a limit price of $10.0
-> LO says: sell at e10.0 or better (in this case higher price since it is a sell!)
-> the order is executed in 2 parts
-> part 1: 50 shares sold at $10.1
-> part 2: 50 shares sold at $10.0
-> the best bid is used, the spread widens ($0.1 → $0.2)
-> Price priority first
-> Limit order to buy 250 shares with a limit price of $10.3
-> 50 shares bought at $10.2, and 50 shares at $10.3
-> what about the rest? Euronext: converted into a LO
-> Note: this LO occurs in the book at the bid side!!
-> Market-to-limit order to sell 175 shares, don’t walk the book
-> 50 shares sold at $10.3
-> what about the rest? Euronext (see Rulebook): converted into a LO
-> Note: this LO occurs in the book at the ask side!!
4
H8
driven markets
1. Introducti on
-> After having discussed dealer markets (Part 2), we now turn to limit order markets (LOM, also
called order-driven markets)
-> Almost all large stock exchanges are order driven or have an important order-driven element in
their design
-> Euronext, Tokyo Stock Exchange
-> NYSE: dealer competes with limit order book (LOB)
-> Some alternative trading systems (i.e. ECNs, see Part 4) function essentially as anonymous
limit order books
-> Also other securities trade in electronic limit order markets (or at least allow for customer limit
orders in addition to on-exchange marketmaking)
-> example: Liffe (derivatives), MTS (bonds)
-> limit order book introduced in FOREX market
-> A detailed discussion by means of an example of the functioning of limit order markets will be
given in the next section
-> the order book has a small-trade positive bid-ask spread, and limit orders profit from small
trades
-> the electronic exchange provides as much liquidity as possible in extreme situations
-> the limit order book does not invite competition from third market dealers, while other
trading institutions do
-> if an entering exchange earns nonnegative trading profits, the consolidated price
schedule matches the limit order book price schedule
-> Suppose a trader submits a limit order to sell
-> Can’t we see this as something very similar to a quote of a dealer, but just having another
name?
-> No! We miss an important element since the perspective is different
-> in a dealer market there is a sharp distinction between liquidity suppliers and demanders
-> in a LOM this distinction becomes blurred I As we will see, agents choose dynamically
whether they want to supply liquidity (submit a limit order), or demand liquidity (by using
a market order)
-> So, order choice will be a main topic in this part on LOMs!
1
H8
,-> There are no dealers with an obligation to post quotes
-> Trading is directly between traders
-> Traders have to choose between submitting a limit order (LO) and a market order (MO)
-> we ignore other order types
-> marketable limit orders are considered to be market orders
-> LO are stored in the limit order book for possible future execution against incoming
MO
-> MO are said to demand liquidity from the market
-> LO are said to supply liquidity to the market
2. Example: conti nues order-driven market
-> Assumptions
-> We start with an empty limit order book (LOB)
-> tick size (minimum price variation) is e 0.1 (Note that e.g. on Euronext this is much smaller (as
small as 0.005 or 0.001 euro)).
-> We now look at how the LOB is affected by a number of incoming orders
-> Limit order to sell with price $10.2 (or better) and quantity 100 (price and quantity = limit order)
-> Limit order to buy with price $10.0 (or better) and quantity 150
-> Best ask = $10.2
-> Price at which a next trader can buy (but results from limit sell!!)
-> Best bid = $10.0
-> Price at which a next trader can sell (but results from limit buy!!)
-> Bid-ask (inside) spread = $0.2 = 2 ticks
-> Depth at best ask is 100 shares, depth at bid side is 150
-> Limit order to sell with price $10.3 and quantity 50
-> Limit order to sell with price $10.6 and quantity 250
-> Limit order to buy with price $0.99 and quantity 175
(Note: the trader makes a typo in the order!)
-> Not all markets check for these typo’s
-> We now have limit order book
-> How are new incoming orders matched with the LOB? In particular, how is determined which
orders in the LOB are executed against the incoming order
-> 2 main rules are generally applied = order precedence rules
1) price priority : orders with a better price are executed first
2) time priority : when orders have the same price, an order that was submitted earlier is
executed first
2
H8
,-> Market order to buy 50 shares (you don’t specify a price, so it’s a market order)
-> this order is executed at the best price possible in the market, i.e. the best ask
-> depth at the best ask decreases with 50
-> When there are 2 market orders, then we look at the time priority
-> Time priority is always secondary to price priority
-> Assume you submit a (pure) market order to sell 280 shares
-> this order is executed at the best price possible in the market, i.e. the best bid
-> but depth at best bid is only 150 → 150 shares are sold at e 10.0
-> rest of the order is executed at the second best bid → 150 shares are sold at e 0.99!!!
-> Market orders without price limit are dangerous!
-> Order that walks the book
-> when 1 bid price doesn’t have enough shares, then you automatedly go to the
next price
-> Other example
-> Limit order to buy 50 shares at a limit price of $10.3
-> Best ask in market is $10.2
-> LO says: buy at $10.3 or better, so the order is executed at the best ask
-> this is a marketable limit order = a limit order that can be executed immediately
-> As if it is a market order, but with a limit, so it prevents it to walk the book to far
-> Limit order to buy 50 shares at a limit price of $10.1
-> best ask in market is $10.2
-> LO says: buy at $10.1 or better, so the order cannot be executed
-> it is recorded in the book
-> the best bid is improved (undercutting), the spread narrows
3
H8
, -> Steal order: that are old orders that haven’t been cancelled yet
-> Limit order to sell 100 shares at a limit price of $10.0
-> LO says: sell at e10.0 or better (in this case higher price since it is a sell!)
-> the order is executed in 2 parts
-> part 1: 50 shares sold at $10.1
-> part 2: 50 shares sold at $10.0
-> the best bid is used, the spread widens ($0.1 → $0.2)
-> Price priority first
-> Limit order to buy 250 shares with a limit price of $10.3
-> 50 shares bought at $10.2, and 50 shares at $10.3
-> what about the rest? Euronext: converted into a LO
-> Note: this LO occurs in the book at the bid side!!
-> Market-to-limit order to sell 175 shares, don’t walk the book
-> 50 shares sold at $10.3
-> what about the rest? Euronext (see Rulebook): converted into a LO
-> Note: this LO occurs in the book at the ask side!!
4
H8
