Locks and Crosses in the Foreign-Exchange Electronic Communication - - PowerPoint PPT Presentation

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion

Locks and Crosses in the Foreign-Exchange Electronic Communication Networks

Ly Tran Last updated: Apr 30, 2015

Ly Tran Locks and Crosses 1/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

A Normal Limit-Order Book

1.5168 1.517 1.5172 1.5174 1.5176 Price 1 5 10 20 40 80 160 320 Depth amount Bid Ask Mid-quote

EUR, Mar 03, 2008, 9:26 am

Spread > 0, or Bid < Ask

Ly Tran Locks and Crosses 2/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Locks & Crosses in Limit-Order Book Dataset

1.543 1.5432 1.5434 1.5436 1.5438 1.544 Price 1 5 10 20 40 80 160 320 Depth amount Bid Ask Mid-quote EUR, May 07, 2008, 11:12 am

Spread = 0,or Bid = Ask

1.5376 1.5378 1.538 1.5382 1.5384 1.5386 Price 1 5 10 20 40 80 160 320 Depth amount Bid Ask Mid-quote EUR, May 07, 2008, 4:28 pm

Spread < 0,or Bid > Ask

Ly Tran Locks and Crosses 3/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Locks & Crosses not Data Errors

L&C Locks Crosses Sources FX Dataset 32% 8% 24% Nasdaq, Pre-open 35% 11% 24% Cao et al. 2000 Nasdaq, Reg. hours 11% 9% 2% Shkilko et al. 2008 NYSE, Reg. hours 5% 3% 2% Shkilko et al. 2008 ”Abnormality” only observed at and inside the quotes

Ly Tran Locks and Crosses 4/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Locks & Crosses in Practice

Security Exchange Commission

Rule 4613 (2000): Nasdaq, trading hours Rule 610 (2007): prohibits locks & crosses

Proponents: rules resolve issues of non-positive spreads

Confusion and unfairness to market participants Slow trading: halt auto-execution, trigger manual execution

Opponents: rules create unintended consequences

Lack of transparency; breeding new order types Increase in high-frequency trading

Ly Tran Locks and Crosses 5/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Locks & Crosses in Academic Literature

Nasdaq preopening: signals to price discovery Nasdaq & NYSE trading hours

Friction among networks Maker-taker pricing Order-in-transit

Ly Tran Locks and Crosses 6/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Contributions

Three hypotheses on locks and crosses Locks Crosses Information

• Market conditions
• Make-taker fees
• Implications

Locks & crosses in unregulated market Limit-order books carry information

Ly Tran Locks and Crosses 7/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

Outline

1

Motivation Observation of ”Abnormality” Locks & Crosses by Different Views Contributions

2

Dataset

3

Three Hypotheses on the Origin of Locks & Crosses Information hypothesis Market Fragmentation Maker-Taker Pricing

4

Conclusion

Ly Tran Locks and Crosses 8/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion

Large High-Frequency Dataset

Minute-by-minute February 28th - June 3rd, 2008 7 currencies vis-a-vis USD

EUR, JPY, GBP, AUD, CHF, CAD, NZD

Aggregated from 7 distinct ECNs

Reuters, EBS, Hotspot, Lava, Currenex, FXCM, and eSpeed

16 series per currency

Best bid, best offer Best marginal price at which one could buy or sell

5mn, 10mn, 20mn, 40mn, 80mn, 160mn, 320mn

Ly Tran Locks and Crosses 9/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion

Snapshot of Limit-Order Book

1.5168 1.517 1.5172 1.5174 1.5176 Price 1 5 10 20 40 80 160 320 Depth amount Bid Ask Mid-quote

EUR, Mar 03, 2008, 9:26 am

Total almost 1 million observations

Ly Tran Locks and Crosses 10/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Three Hypotheses

Information hypothesis Locks and crosses are created to convey information held by traders Market fragmentation hypothesis In fragmented market, market conditions affect locks’ and crosses’

• ccurrences

Maker-taker pricing hypothesis Pricing schemes that favor liquidity makers over liquidity takers encourage locks and crosses occurrences

Ly Tran Locks and Crosses 11/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Information Hypothesis

Hypothesis Locks and crosses are created to convey information held by traders Examine relationship

Price movement ”during” & after normal, lock, cross Locks & crosses: size, net depth Future price dynamics: returns, volatility

Ly Tran Locks and Crosses 12/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Intensity of Price Contribution

Intuition

Does price tend to move more during locks, crosses, or normal markets?

Measure IPC c,mk

t

=

• m∈t
• ∆Pc,mk

m

• m∈t |∆Pc

m|

• m∈t I c,mk

m

• c

Currency ∆P Change in price m, t Time subscripts mk Market type lock, cross, normal I mk Index, = 1 if market is mk

Ly Tran Locks and Crosses 13/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Crosses Contribute More to Price Changes

Findings

Crosses contribute more than normal and locked markets Locks is not different from normal markets

Literature

Locks and crosses contribute more than normal markets Crosses contribute more than locks

Lock/Norm Cross/Norm Total 1.11 2.13*** EUR 1.07 2.54*** JPY 1.05 2.48*** GBP 1.15 2.05*** AUD 0.97 2.28*** CHF 1.08 1.46** CAD 1.15 1.45* NZD 1.34* 2.66***

Ly Tran Locks and Crosses 14/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Net Depth Measures Order Imbalance

Best bid Best ask OverlapDepth

bid

OverlapDepth

ask

Net depth = OverlapDepth

bid - OverlapDepth ask

Ly Tran Locks and Crosses 15/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Cross Net Depth Predicts Future Returns

In-sample predictive power for future returns retsc,mk

m+T = α + βc,mknetdepc,mk m

+ εc

m

5 10 Coefficients , units of .01 1 5 m i n 1 / 2 h

• u

r 1 h

• u

r 1 . 5 h

• u

r 2 h

• u

r 3 h

• u

r 6 h

• u

r 9 h

• u

r 1 2 h

• u

r 1 d a y

b

c,mk

95% CI Cross Ly Tran Locks and Crosses 16/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Lock Net Depth Not Associated with Returns

• 2

2 4 6 8 Coefficients , units of .01 1 5 m i n 1 / 2 h

• u

r 1 h

• u

r 1 . 5 h

• u

r 2 h

• u

r 3 h

• u

r 6 h

• u

r 9 h

• u

r 1 2 h

• u

r 1 d a y

b

c,mk

95% CI Lock

Non-significant coefficients

Ly Tran Locks and Crosses 17/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Cross Size Anticipates Volatility

CrossSize = |Spread|Spread<0 volc,T

m+1 = φ + γTCrossSizec m + uc m

.05 .1 .15 .2 .25 .3 Coefficients 1 / 2 h

• u

r 1 h

• u

r 1 . 5 h

• u

r 2 h

• u

r 3 h

• u

r 6 h

• u

r 9 h

• u

r 1 2 h

• u

r 1 d a y

g

T

95% CI Cross Size Coefficients Ly Tran Locks and Crosses 18/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Locks, Crosses, and Price Discovery

Cross variables convey information

⇑ Cross size → ⇑ Future volatility ⇑ Cross net depth → ⇑ Future returns Consistent with information hypothesis

Locks not associated with future price dynamics

Does not support information hypothesis

Ly Tran Locks and Crosses 19/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Market Fragmentation Hypothesis

Hypothesis In fragmented market, market conditions affect locks’ and crosses’

• ccurrences

Conjecture for increases in probability of locks and crosses:

High volatility & low depth at quotes

→ ⇑ Friction across networks

Delayed quote updates

Ly Tran Locks and Crosses 20/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Market Fragmentation Results in More Locks & Crosses

Market conditions associated with increasing probability Locks Crosses Narrow spreads

• High volatility
• Low depth at quotes
• Locks & crosses created due to market fragmentation

Locks occur more consistently regardless of volatility & depth at quotes

Ly Tran Locks and Crosses 21/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Maker-Taker Pricing Hypothesis

Hypothesis Pricing schemes that favor liquidity makers over liquidity takers encourage locks and crosses occurrences What is it? Pricing scheme

Equity exchanges often

Rewards liquidity makers (e.g. 20 cents/100 shares) Penalizes liquidity takers (e.g. 30 cents/100 shares)

Other approaches also available

Foreign-exchange ECNs

No liquidity rebates, but Some charge liquidity takers more than liquidity makers

E.g.: 0.01bps/1$ (Hotspot)

Ly Tran Locks and Crosses 22/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Cross Size Exceeds Spread

2 4 6 8 10 12 Ratio 2 4 6 8 10 Basis points EUR JPY GBP AUD CHF CAD NZD Cross size Spread Cross size/Spread

Maker-taker pricing only supports small cross size and locks

Ly Tran Locks and Crosses 23/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion Information hypothesis Market Fragmentation Maker-Taker Pricing

Results are Robust to Multiple Specifications

Sub-segments of data

Biweekly Monthly Half-period

Volatility

Calculated from 1-minute vs. 5-minute returns During high vs. low volatility periods

Individual currency as well as panel data Locks include small cross sizes

Ly Tran Locks and Crosses 24/25

Motivation Dataset Three Hypotheses on the Origin of Locks & Crosses Conclusion

Conclusion

Information hypothesis

Crosses contribute more to price changes Crosses have predictive power for future volatility and returns

Market conditions in fragmented market

Crosses associated with spread, volatility, and depth Locks associated with narrow spreads Locks could happen by chance

Maker-taker pricing

Locks, but not crosses

Implications

Limit-order book carries information

Ly Tran Locks and Crosses 25/25