Friday, July 30, 2004

Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU

Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU

Boehmer, Saar, and Yu give us an interesting look at how transparency affects trading. Specifically they examine how trades happen at the NYSE after the 2002 adoption of OpenBook. OpenBook is "allows traders off the NYSE floor to observe depth in the book in real time at each price level for all securities. Before the introduction of OpenBook, only the best bid and offer (representing orders in the book, floor broker interest, and the specialist's own trading desires) had been disseminated."

The current paper empirically examines the theoretical predictions of previous authors who have hypothesized that allowing traders to know more, may affect how they trade. For instance "Harris (1996) discusses two risks that are associated with the exposure of limit orders: (i) A trader may reveal to the market private information about the value of the security, and (ii) exposed limit orders can be used to construct trading strategies aimed explicitly at taking advantage of these limit orders."

This of course is not surprising. If you know what the other traders are doing (or are willing to do), that information will almost certainly influence your own trading.

Boehmer, Saar, and Yu find some confirmation of this: "After OpenBook is introduced [we] find a higher cancellation rate and shorter time-to-cancellation of limit orders in the book. We also find smaller limit orders after the change in transparency. This evidence is consistent with the idea that traders attempt to manage the exposure of their orders." (pp. 2-3)

OpenBook also impacts those who work at the NYSE. For instance the authors report "We find that the specialist participation rate in trading declines following the introduction of OpenBook. We also find that specialists reduce the depth they add to the quote (together with floor brokers) beyond what is in the limit order book. These changes in trading strategies are consistent with an increase in the risk of proprietary trading on the part of specialists
due to loss of their information advantage."

To see whether these changes have a good or bad impact on market prices and efficiency, the authors examine price movements before and after adoption (Hasbrouck's 1993 variance decomposition). They find: "smaller deviations of transaction prices from the efficient (random walk) price. We also find some indication (though weak) of a small
reduction in the absolute value of first-order return autocorrelations calculated from quote midpoints. These results are consistent with more efficient prices that are less subject to overshooting and reversal following the introduction of OpenBook." In non finance speak: prices bounce around less.

Additionally they find that the effective spreads drop, but they are quick to point out that this does not necessarily mean that total transaction costs drop. Why? It is likely because by breaking up their trades and cutting in front, the effective spread is narrowed. However, because there are more smaller trades, overall transactions costs may remain the same.

The loser in all of this? The specialist. "The evidence of a decline in effective spreads of trades suggests that the costs incurred by liquidity demanders decrease with the introduction of OpenBook. This evidence may also suggest a decline in investors’ compensation for exposing limit orders and supplying liquidity. The decrease in the participation rate of specialists is consistent with such erosion in the profitability of liquidity provision."

In wrapping up the authors summarize some of the consequences of their findings:

1. "We find that investors do change their strategies in response to the change in market
design: They submit smaller limit orders and cancel limit orders in the book more quickly and
more often. These findings are consistent with a more active management of trading strategies in
the face of greater risk of order exposure. Additionally, we find that traders shift activity away
from floor brokers toward electronically submitted limit orders."

2. "The results we document point to two welfare redistributions that are possibly associated with the introduction of OpenBook. The first is from liquidity suppliers to demanders. The decrease in the price impact of trades and marketable orders reduces the compensation for liquidity provision, hurting limit order suppliers and specialists. The second is from NYSE members to the exchange itself. We document a decrease in the specialist participation rate, and the evidence of a shift from floor to limit orders is consistent with a decline in the business of floor brokers. At the same time, the NYSE generates revenues from the OpenBook service."

This paper is forthcoming in the Journal of Finance.

The abstract is available at

The paper is also available through FEN.

As an aside, market microstructure papers, while fascinating at some levels, often have the ability to bore those who are not already excited about finance. Hence I sometimes shy away from reviewing papers that are totally microsturcture oriented. This one however, is the exception. It is definitely interesting enough that it willhold the attention of even those who are only mildly interested in the topic and thus should be able to be used in class with no problems!

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