Middlemen in Limit-Order MarketsMiddlemen in Limit Order Markets

Boyan Jovanovic & Albert Menkveld

B d J Beograd, June 22, 2011

BackgroundandMotivation

Middlemans overall inventory of ING (a Dutch Bank) over one trading day

(proprietary trader)

Hard vs. soft information

Middleman reacts to news faster and in the right direction

Speed (count) and direction (correlation)

I b t N XIncumbent = NyX Entrant = ChiX

Comparing the blue circles 1.13/1.6 is roughly 2/3Therefore the middleman is in roughly 2/3 of the trades on ChiX,

and in fewer than 1/5 of the trades on NyX

Markets are thin.

Facts:

Since Chi-X opened in 2007,

1. Decline in bid-ask spreads by 35%

2. Decline in Trading by 13%

Also, Middlemen are

a) Fastera) Faster

b) More active when hard information is more volatile

Literature

-- Foundations of the REE-- Foundations of the REEDubey Genakoplos Shubik 87 Wolinsky 90,Golosov Lorenzoni Tsyvinski 09

-- MiddlemenRubinstein & Wolinsky 87 Li 98

-- Limit-order mktsGlosten Milgrom 82 Goettler Parlour Rajan 09, Bi i & W ill 09Biais & Weill 09

winners curse

Glosten & Milgrom 82Glosten & Milgrom 82

i i hibi dwinners curse inhibits trade

Q: do HFTs make things worse or better?

A: Market survival & bid-ask spreads says betterA: Market survival & bid ask spreads says better

Volume evidence says worse

y

1

y

First-best

0.5 transfer

45

1 x45

0

V i 1 N d l ti t th t tVersion 1: No adverse selection at the outset

Neither B nor S has signal on zg

One-period (continuation value = zero)One-period (continuation value = zero)

Fi t l k t ith t MFirst look at case without M

Then add M

1

y

TRADE

0.5 (1+x)/2

= 0.25

1 x45

0

1

y 0.5

TRADE 2x

0.5

1 x45

0 = 0.25

y0.5

1

Transfersamong

0.5

(1+x)/2amonginvestors

2xTransfertoMiddleman

1 x45

0 0 250.25

Trading through a middleman

Effect of M

Bid ask spread go downBid ask spread go down

Welfare & trade go down, but less than the change in shaded area

Conclusion: with no winners curse, M make things worse

Second-period subgame between M and B

Alpha = 0.42 Lambda = 0.9

Bid-ask spread

welfarewelfare

# trades

C ti t ti ith tComparative statics with respectto lambda

Bid-ask spread welfare

# trades

C ti t ti ith tComparative statics with respectto theta

Bid-ask spread

welfare

p

C ti t ti ith tComparative statics with respectto alpha

Conclusion

Markets are thin

M bring in competition

Informed, yes, but passive & competitive

Fall in bid-ask spreads GOOD

Failure of trade to rise indicates crowding out BADFailure of trade to rise indicates crowding out BAD

Market share evidence (Stiglers survivor test) GOODMarket share evidence (Stigler s survivor test) GOODOr is it a simple decline in entry costs? Still, customer has chosen to trade in new markets