INFORMATION FLOW IN A FRAGMENTED DEALER MARKET: THREE ESSAYS ON PRICE DISCOVERY DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Laura A. Tuttle, M.B.A. ***** The Ohio State University 2004 Dissertation Committee: Approved by Professor Ingrid Werner, Adviser _________________________ Professor Andrew Karolyi Adviser Professor René Stulz Graduate Program in Business Administration ii Abstract The 1990's were a period of rapid change in the trading of Nasdaq stocks. Advances in network technology improved the market's ability to trade efficiently and disseminate real-time information. Concurrently, regulatory changes mandated inclusion of alternate trading venues in the quote montage, and restricted the manner in which customer limit orders are handled by market makers. This dissertation explores the price formation process in the Nasdaq market, examining how fragmentation and imperfect transparency affects price formation. The first essay, “Price Discovery in Nasdaq Issues”, investigates price leadership relationships between Nasdaq market makers and Electronic Communications Networks (ECNs). Using the Hasbrouck information share and Gonzalo-Granger common factor methodologies, I show that ECNs provide more than half of the price discovery for approximately one out of three Nasdaq 100 stocks, although ECNs trades account for less than 33% of any Nasdaq 100 issue's trading activity. The second essay, “Hidden Orders, Trading Costs and Information”, explores non-displayed (reserve) depth in Nasdaq market maker quotes in SuperSOES. While the presence of hidden depth at the inside has no effect on effective half-spreads, the information content of a trade (as measured by the midquote adjustment in the 30 minutes post-trade) is lower when reserve size is quoted, suggesting reserve size signals short-term price movements. Displayed depth does not predict daily returns, but the non-displayed orders of investment banks and wirehouses are indicative of daily price changes. In the final essay, “News or Noise: Is the Price Impact of Island Trades Persistent?”, I examine the trades on the Island ECN to discover whether their information impact is transient or permanent. I measure price iii impact at a number of horizons, allowing for the possibility of price reversals from liquidity motivated trades. Using simple regressions, I show Island trades are more informative than other trades only at short time horizons post-trade; at longer horizons, the price impact of an Island trade is not significantly different from trades in other venues. Island trades can be shown to be more informative at longer horizons only when the experimental design controls for the endogeneity of the trading venue decision. iv ACKNOWLEDGMENTS I would like to express my deepest gratitude to my advisor, Ingrid Werner, for her encouragement and guidance throughout my dissertation research. She has been not only an advisor, but a mentor who inspires me both professionally and personally. I am also indebted to Andrew Karolyi and René Stulz for their innumerable ideas and suggestions to improve and extend this research. I am grateful to Karen Wruck and Spencer Martin for helpful suggestions, ideas for future research, timely advice and indispensable encouragement. I thank my family for their endless encouragement and support. I am deeply grateful to my colleagues for their assistance and friendship while completing my dissertation, particularly Rodolfo Martell, Boyce Watkins, Christo Pirinsky, and Christof Stahel. Words cannot express my appreciation for the friendship and encouragement of my colleague Nicole Boyson. I thank Ralph Walkling for his faith in me. I am thankful for the opportunity to visit Nasdaq Economic Research and thank Nasdaq for access to proprietary data. I gratefully acknowledge the assistance of Tim McCormick, Frank Hatheway, Jeffrey Smith and the staff of Nasdaq Economic Research. I also wish to thank seminar participants at Nasdaq Economic Research, The Ohio State University, the University of Dayton, Oregon State University, Florida State University, the University of Kansas, the University of Georgia and the University of Missouri (Kansas City). v VITA December 15, 1969 ………………………………………… Born – Kansas City, Missouri 1990……………………………………… …………………B.S., Agriculture, Kansas State University 1995 ………………………………………………………… M.B.A., Northern Illinois University FIELDS OF STUDY Major Field: Business Administration Concentration: Finance vi TABLE OF CONTENTS Absrtact ii Acknowledgments iv Vita v List of Tables viii List of Figures x Chapters: 1. Introduction 1 2. Price Discovery Using Quotation Data 6 2.1 Introduction 6 2.2 Cointegration and Price Discovery Measures 9 2.3 Data and Methodology 17 2.4 Results 21 2.5 Conclusion 23 3. Imperfect Transparency: the Role of Non-Displayed Depth 25 3.1 Introduction 25 3.2 Motivation and Data Description 28 3.2.1 Motivation 28 3.2.2 Description of Data 31 3.3 Methodology and Results 36 3.3.1Market depth 36 3.3.2 Cross-sectional Determinants of Hidden Depth 38 3.3.3 Trading Costs and Informational Efficiency 41 3.3.4 Hidden Size, Information and Events: Earnings Releases 44 3.4 Conclusion 48 vii 4. The Persistence of Island ECN Trade Price Impact 50 4.1 Introduction 50 4.2 Trading of Nasdaq Securities 53 4.3 Data and Methodology 56 4.3.1 Data 56 4.3.2 Methodology 57 4.4 Results 61 4.4.1Simple Regressions 64 4.4.2 Endogenous Switching Regressions 67 4.5 Conclusion 69 5. Conclusion 70 List of References 73 Appendix A 78 Appendix B 82 Appendix C 84 Appendix D 110 viii LIST OF TABLES Table 1: Descriptive Statistics for Sample 85 Table 2: Descriptive Statistics for Market Maker versus ECN Quotations 86 Table 3: Trace Test for Cointegration Rank 87 Table 4: Information Share and Common Factors with Alternative Normalization 88 Table 5: Price Discovery by ECNs and Market Makers 89 Table 6: Price Discovery by ECNs and Market Makers 90 Table 7: Characteristics of Sample Stocks 92 Table 8: Near-Inside Depth for Nasdaq Stocks 2001 and 2002 93 Table 9: Inside Market Participant by Type 94 Table 10: NYSE/Nasdaq Depth Comparison Between June 2001 and April 2002 95 Table 11: Cross-Sectional Regressions of Proportion of Hidden Size 96 Table 12: Determinants of Trading Cost and Price Impact 97 Table 13: Determinants of Trading Cost and Price Impact 98 Table 14: Returns for Portfolios Classified by Displayed Bid-Offer Depth Imbalances 99 Table 15: Returns for Portfolios Classified by Reserve Bid-Offer Depth Imbalances 100 Table 16: Returns for Portfolios Classified by Displayed Bid-Offer Depth Imbalances on Earnings Release Days 101 Table 17: Returns for Portfolios Classified by Reserve Bid-Offer Depth Imbalances on Earnings Release Days 102 Table18: Sample Stock Characteristics 103 Table 19: Trade Characteristics 104 Table 20: Mean Post-Trade Midquote Revision by Trade Size 105 ix Table 21: Simple Regressions of Post-Trade Midquote Revision 106 Table 22: Probit Model Estimates 107 Table 23: Second-Stage Price Impact Regressions 108 Table 24: Simulation Results 109 x LIST OF FIGURES Figure 1: QQQ Price: May-July 2001 111 Figure 2: QQQ Price: Mar-May 2002 112 [...]... Nasdaq 100 stocks, ECNs quotations contribute more information (more than 50% of all information) than all other Nasdaq quotations combined; none of these stocks has an ECN trading share exceeding 33% Using the information density measure (information share scaled by market share), I show that in the majority (at least 70 of 100) of Nasdaq stocks, ECN quotations contribute a fraction of information. .. efficient price incorporate the information at all lags in the ECM and tend to have a lower variance than innovations to the Gonzalo-Granger common factor constructed as a linear combination of contemporaneous prices In this paper, I will report both measures; the conclusions regarding price discovery leadership are similar with either approach 16 2.3 DATA AND METHODOLOGY My sample is the Nasdaq 100 during... positions accumulated during the trading day (Simaan et al., 1998) The decrease in spreads and changes in intraday spread patterns in the wake of the 1997 OHR revisions raises questions about the flow of information between markets One possible explanation for changes in intraday spread patterns is that information contained in ECN limit orders now enters the aggregate market more efficiently It is also... price formation in the market for Nasdaq securities This dissertation adds to the finance literature concerning price formation in fragmented markets, as well as the literature documenting Nasdaq stock trading in the wake of market reform Barclay et al (1999) describe the dramatic drop in quoted and effective half-spreads in the Nasdaq market both in response to changes in SEC mandated Order Handling... spreads than absolute trading volume This suggests an important role for ECNs in determining market quality by attracting informed traders away from the market maker market and reducing their risks arising from informational asymmetry 8 2.2 COINTEGRATION AND PRICE DISCOVERY MEASURES Price discovery is the process by which new information is revealed by market participants and incorporated into observable... that this competition results in market fragmentation, as restrictions to information or trading access in one market erodes aggregate market quality One factor leading to the ECN Display Rule3 was concern that a two-tier market was developing: institutional traders and market professionals with access to alternative trading systems could trade at better prices than were quoted to other investors (SEC,... care, and traditional retailers, among others Total market capitalization (based on closing price and total shares outstanding on July 1, 1999) ranges from $53.8 billion (Oracle Corporation) to $1.1 billion (First Health Group Corporation) The time-weighted average of ECN participation in the inside market varies from a high of 51% (Amazon.com, Inc.) to a low of 4% (Oracle Corporation) All of the sample... is akin to the high-noise, high-news case in the simulation and thus the Hasbrouck information share measure is a better measure of information attribution than the GG common factor measure In all likelihood, both measures underestimate the information originating in the ECN market, as we would expect as the ECN market appears noisier than the market maker market 2.5 CONCLUSION 20 Because theΨ(1) matrix... GonzaloGranger methodology constructs an implied efficient price that is a linear combination of contemporaneous prices in multiple markets; the innovations to the efficient price result from imposing orthogonality conditions on the error-correction terms in a Granger error-correction model In contrast, the Hasbrouck information share implies an efficient asset price constructed as linear combinations... and have a significantly larger variance than the innovations in the random walk described by the Stock and Watson common trend model (Hasbrouck, 2000) A third approach to attribution of price discovery is presented by Hasbrouck (1995) Hasbrouck introduces the information share measure which captures the variation in the underlying random walk introduced by each market Assuming that each market's price . information is revealed by market participants and incorporated into observable asset prices. In the case of an asset that trades in multiple markets, innovations in price can be revealed in. 2001 1 ; and a growing proportion of Nasdaq trading is originating on proprietary trading systems without the participation of Nasdaq market makers 2 . 1 NasdaqTrader web site, www.nasdaqtrader.com as restrictions to information or trading access in one market erodes aggregate market quality. One factor leading to the ECN Display Rule 3 was concern that a two-tier market was developing: