crossing network versus dealer market unique equilibrium in the allocation of order flow the allocation of order flow to alternative trading systems can be understood as a game with strategic substitutes between buyers on the same side of the market as well as one of positive network externalities we consider the allocation of order flow between a crossing network and a dealer market we show that small differences in traders preferences generate a unique switching equilibrium in which patient traders use the crossing network while impatient traders submit orders directly to the dealer market our model explains why assets with large turnovers and low price volatility are likely to be traded on crossing networks while less liquid assets are traded on dealer markets

limit order book as a market for liquidity we develop a dynamic model of an order driven market populated by discretionary liquidity traders these traders must trade yet can choose the type of order and are fully strategic in their decision traders differ by their impatience less patient traders demand liquidity more patient traders provide it three equilibrium patterns are obtained the pattern is determined by three parameters the degree of impatience of the patient traders which we model as the cost of execution delay in providing liquidity their proportion in the population which determines the degree of competition among the liquidity providers and the tick size which is the cost of the minimal price improvement despite its simplicity the model generates a rich set of empirical predictions on the relation between market parameters time to execution and spreads we argue that the economic intuition of this model is so basic its main results must be robust in much more general models

transaction costs order placement strategy and existence of the bid ask spread by considering investor order placement strategy this paper demonstrates that transaction costs cause bid ask spreads to be an equilibrium property of asset markets with transaction costs the probability of a limit order executing does not go to unity as the order is placed infinitesimally close to a counterpart market quote thus with certainty of execution at the counterpart market quote a gravitational pull is generated that keeps counterpart quotes from being placed infinitesimally close to each other an equilibrium spread is defined and its size linked to market thinness implications are noted for the design of a trading system

trading volume and asset liquidity since the depth and liquidity of a market depend on the entry decisions of all potential participants each trader assesses them according to conjectures about entry by others if trade is equally costly across markets this externality leads to the concentration of trade on one market if not it can produce multiple conjectural equilibria some where trade concentrates on one market and others where large traders resort to a separate market or to search for a trading partner while fragmentation is welfare reducing in the two market case no such ranking is possible if it involves off exchange search

tail expectation and imperfect competition in limit order book markets abstract perfect competition in liquidity provision in limit order markets is characterized by a tail expectation condition glosten 1994 in this paper we model imperfect competition in schedules by infinitely many liquidity suppliers quoting on a limit order book we show that there are zero rent mixed strategy equilibria featuring finite numbers of active liquidity suppliers none of the equilibria satisfies the competitive outcome not even on average considering a sequence of equilibria with the number of active liquidity suppliers becoming large we show that the aggregate stochastic marginal price schedule converges to the deterministic competitive marginal price schedule

paying for market quality many financial markets including electronic limit order markets assign designated liquidity providers lps we study the experience of the stockholm stock exchange where listed firms contract directly with lps our analysis offers insights regarding situations where designated liquidity provision may be beneficial in addition we consider the form of liquidity provision contracts including affirmative obligations required of the lp and compensation for lp services we find that low current trading activity wide spreads and higher information asymmetry increase the attractiveness of contracted liquidity provision the evidence indicates that lps trade against market movements and in times of wide spreads on balance firms contracting with lps experience a decreased cost of capital and significant improvements in market quality and price discovery

market making with costly monitoring an analysis of the soes controversy we develop a model of price formation in a dealership market where monitoring of the information flow requires costly effort the result is imperfect monitoring which creates profit opportunities for speculators who pick off stale quotes externalities associated with monitoring give rise to multiple equilibria in which dealers earn strictly positive expected profits we obtain various policy implications a switch to automatic execution can improve or worsen spreads and price discovery depending on the specific equilibrium a reduction in the minimum quoted depth tightens the spread but it reduces price efficiency our analysis is relevant for the soes controversy given that speculators in our model behave as the real world soes bandits our model predicts that soes bandits should trade in stocks with small spreads and that soes bandit activity should widen the spread we provide empirical evidence consistent with these predictions

high frequency quoting short term volatility in bids and offers at subsecond horizons bids and offers in u s equity markets are more volatile than what would be implied by long term fundamentals to assess costs and consequences this paper suggests that traders random delays latencies interact with quote volatility to generate execution price risk and relative latency costs analysis of the behavior of quote setters suggests that this volatility is more likely to arise from recurrent cycles of undercutting similar to the edgeworth cycles found in product markets rather than mixed strategies of limit order placement

trading under market impact crossing networks interacting with dealer markets abstract we use a model with agency frictions to analyze the structure of a dealer market that faces competition from a crossing network traders are privately informed about their types e g their portfolios which is something the dealer must take into account when engaging his counterparties instead of participating in the dealer market the traders may take their business to a crossing network the dealer must take into consideration that traders have this alternative when choosing a pricing schedule we show that the presence of a crossing network may benefit traders even if they do not trade in it furthermore it results in more traders being serviced by the dealer and the book s spread shrinking under certain conditions we allow for the pricing on the dealer market to determine the structure of the crossing network which itself influences the structure of the dealer market this results in a feedback look that under the same conditions that lead to a reduction of the spread yields an equilibrium book crossing network pair

tax analysis in a real business cycle model on measuring harberger triangles and okun gaps abstract a tax distorted real business cycle model is parameterized calibrated and solved numerically in an attempt to measure the size of harberger triangles relative to okun gaps in particular the model constructed is used to study quantitatively the impact of various distortional government tax and subsidy schemes it is shown that the government can use tax policy to stabilize cyclical fluctuations and this is done for the economy being studied the benefits of implementing such a stabilization policy are calculated and compared with the size of the welfare gains realized from reducing various tax distortions

adverse selection and competitive market making empirical evidence from a limit order market this article presents a new methodology for testing economic restrictions on the price schedules offered in a limit order book that are based on i break even conditions for marginal limit orders and ii rational updating conditions for order book revisions over time using order flow data from the stockholm stock exchange i find strong evidence of insufficient depth in the limit order books relative to the theoretical predictions an extended model which allows the model parameters to depend on market conditions captures some of the systematic variation in the observed order book depth article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

anticipated monetary policy in a cash in advance economy this paper analyses the effects of perfectly foreseen monetary policy within the framework of a standard cash in advance economy anticipated monetary policy is shown to have real effects by influencing inflationary expectations in a cash in advance economy an increase in the anticipated rate of inflation reduces the return to labour supply and induces a substitution away from time spent in the labour market the paper analyses the implication of this substitution for the time paths of output prices interest rates real and nominal and stock market prices

competition among trading venues information and trading on electronic communications networks this paper explores the competition between two trading venues electronic communication networks ecns and nasdaq market makers ecns oier the advantages of anonymity and speed of execution which attract informed traders thus trades are more likely to occur on ecns when information asymmetry is greater and when trading volume and stock return volatility are high ecn trades have greater permanent price impacts and more private information is revealed through ecn trades than though market maker trades however ecn trades have higher ex ante trading costs because market makers can preference or internalize the less informed trades and oier them better executions technological innovations that enable high speed low cost electronic trading systems are dramatically changing the structure of nancial markets exchanges and markets around the world are merging or forming alliances to improve liquidity and reduce costs in the face of increased competition from each other and from these computerized trading systems trading volume on electronic communications networks ecns has grown rapidly over the past several years ecns are now involved in more than a third of nasdaq trading volume and are attempting to increase their market share in nyse listed

real balance effects and monetary policy i introduction modern literature on monetary policy rules employs new keynesian optimizing models that do not explicitly include monetary aggregates see e g rotemberg and woodford 1997 clarida et al 1999 taylor 1999 in these models the demand for output derives from the log linearization of the standard euler equation characterizing household s saving decisions the real money stock does not enter the is relation and therefore monetary policy affects output and inflation only through its effect on the real interest rate when the nominal interest rate is the policy instrument it is not necessary to specify a money market equilibrium condition see romer 2000 the practice of neglecting monetary aggregates in monetary policy analysis has recently been questioned by meltzer 1999 mccallum 2001 and nelson 2002 2003 in particular mccallum 2001 points out that although no explicit term involving money appears in the standard new keynesian setup long run inflation can still be pinned down by the economy steady state nominal money growth rate moreover mccallum 2000 2001 andres et al 2001 kremer et al 2003 woodford 2003 ireland 2004a and collard and dellas 2005 analyze the case in which the resources used by consumers in conducting transactions are modeled by a nonseparable function of consumption and real money balances meltzer 1999 2001 argues that changes in real monetary base generate effects on real aggregate demand not summarized by the real interest rate on short term securities nelson 2003 emphasizes the role of money in the transmission mechanism both as a proxy for a whole spectrum of rates of return and as an indicator variable which contains information about the state of the economy the main aim of the present article is to provide additional microfoundations for an explicit role for money in the current macroeconomic debate in particular i derive a real balance effect that explicitly enters the is relation within an optimizing general equilibrium framework of the new keynesian type according to de scitovszky 1941 haberler 1946 pigou 1943 and patinkin 1965 a change in real money balances has an impact on the real financial wealth of consumers and therefore affects consumption and output notably this effect is not considered in traditional models there is in fact empirical evidence showing that real monetary base growth is a significant determinant of consumption and output gap in both the united states and in the united kingdom see chari et al 1995 meltzer 1999 nelson 2002 the present article extends the dynamic stochastic new keynesian setup with money in the utility function by introducing overlapping generations as modeled by yaari 1965 and blanchard 1985 there are good reasons to base the demand side of the economy on a discrete time stochastic monetary version of the yaari blanchard model first this kind of extension allows one to maintain the main characteristics of the so called new neoclassical synthesis that is forward looking behavior of optimizing agents and incomplete nominal adjustment of prices featured in new keynesian theories goodfriend and king 1997 second the derivation of the real balance effect does not require nonseparability in the utility function thus the implications are analytically more tractable 1 third my framework is more general because it includes the immortal representative agent setup as a particular case my analysis attempts to examine whether the presence of an explicit real balance effect in the is relation helps evaluate the role for money in designing monetary policy rules i focus on basic issues concerning the design of monetary policy rules specifically i investigate whether it is necessary for monetary policy to overreact to inflation by raising the nominal interest rate by more than the observed increase in inflation to rule out equilibrium multiplicity

a further exploration in the theory of exchange rate regimes in an interesting paper in this journal elhanan helpman 1981 develops a simple two country model to compare the welfare levels that are achieved under different exchange rate regimes in a world characterized by perfect foresight his basic finding is that equilibrium consumption allocations and hence welfare levels are identical under a floating exchange rate system and a one sided peg fixed exchange rate regime this result is due to helpman s assumption that output is determined exogenously which allows a separation of the real and monetary sides of the economy the purpose of this paper is to extend helpman s model by making two alterations in his setup 1 to allow production to be endogenously determined as a function of labor force participation and 2 to allow welfare levels to be dependent on labor service as well as on consumption the main conclusion then obtained is that a country may achieve a higher welfare level under a flexible exchange rate regime than under a fixed exchange rate regime since it is able to choose an optimal rate of inflation or currency depreciation

trading fees and efficiency in limit order markets competition among trading platforms has considerably reduced trading fees in stock markets we show that this evolution is not necessarily beneficial to investors although they increase gains from trade when a trade happens lower trading costs can induce investors to post limit orders with a smaller execution probability in this case gains from trade are realized less frequently and investors can be worse off our model has testable implications for the effects of trading fees and their breakdown between liquidity suppliers and liquidity demanders on limit order fill rates and bid ask spreads

liquidity based competition for order flow we present a microstructure model of competition for order flow between exchanges based on liquidity provision we find that neither a pure limit order market plm nor a hybrid specialist limit order market hm structure is competition proof a plm can always be supported in equilibrium as the dominant market i e where the hybrid limit book is empty but an hm can also be supported for some market parameterizations as the dominant market we also show the possible coexistence of competing markets order preferencing that is decisions about where orders are routed when investors are indifferent is a key determinant of market viability welfare comparisons show that competition between exchanges can increase as well as reduce the cost of liquidity active competition between exchanges for order flow in cross listed securities is intense in the current financial marketplace examples include rivalries between the new york stock exchange nyse crossing networks and ecns and between the london stock exchange the paris bourse and other continental markets for equity trading and between eurex and london international financial futures and options exchange liffe for futures volume while exchanges compete along many dimensions e g payment for order flow transparency execution speed liquidity and price improvement will in our view be the key variables driving competition in the future over time high cost markets should be driven out of business as investors switch to cheaper trading venues moreover market structure is increasingly singled out by regulators exchanges and other market participants as a major determinant of liquidity 1

comovement information production and the business cycle abstract recent theoretical research suggests that information production is a positive externality of aggregate economic activity veldkamp 2005 both the quantity and quality of information increase during periods of economic expansion and decrease during periods of contraction based on this insight we hypothesize and confirm that time varying information production drives the comovement patterns observed in stock returns we examine stock return comovement in 36 countries from 1980 to 2007 and show that consistent with the theory comovement patterns are countercyclical that is when information production is high low comovement is low high we also find that the relation between comovement and the business cycle is stronger in countries that experience large intertemporal swings in information production finally we show that the relation between business cycle and comovement is stronger in poor countries countries with less developed financial markets and countries with weaker accounting and transparency standards these results suggest that financial development and transparency are conducive to a steady flow of financial information over the business cycle

island goes dark transparency fragmentation and regulation responding to a september 2002 regulatory enforcement the island electronic communications network stopped displaying its limit order book in the three most active exchange traded funds etfs where it was the dominant venue island s share of trading activity and price discovery fell fragmenting the market etf prices adjust more slowly when island goes dark and there is substantial price discovery movement from etfs to the futures market trading costs increase on island and decrease off island with higher trading costs overall when island later redisplays its orders market quality improves with transparency and the reduction in fragmentation both playing important roles copyright 2005 oxford university press

the welfare cost of inflation under imperfect insurance abstract this paper examines the welfare cost of inflation in an economy where agents hold money in order to smooth consumption in the face of income variability for which there is no insurance the findings indicate that for the type of economies considered here the area under the empirical money demand curve is a poor measure of the welfare cost of inflation this area accounts for only one fourth of the true costs in the case of 5 inflation

anticipated inflation and the capital stock in a cash in advance economy abstract an economy is constructed in which the steady state capital stock is inversely related to the rate of inflation as a result that is directly opposite the usual conclusion

money and growth revisited abstract conventional wisdom is that if public policy can affect the growth rate of the economy the welfare implications of alternative policies will be large in this paper a stochastic dynamic general equilibrium model with endogenous growth and money is examined in this setting inflation lowers growth through its effect on the return to work however the welfare costs of higher inflation are modest the endogenous labor supply is important in producing this result

competition among exchanges does competition among e nancial intermediaries lead to excessively low standards to examine this question we construct a model where intermediaries design contracts to attract trading volume taking into consideration that traders differ in credit quality and may default when credit quality is observable intermediaries demand the right amount of guarantees a monopolist would demand fewer guarantees private information about credit quality has an ambiguous effect in a competitive environment when the cost of default is large small private information leads to higher lower standards we exhibit examples where private information is present and competition produces higher standards than monopoly does i introduction in spite of the general acceptance of the competitive mechanism as an allocation scheme many observers consider e nancial intermediation an exception competition is thought to lead to a race to the bottom in which e nancial intermediaries settle for excessively low levels of contractual guarantees in an attempt to increase volume evaluating futures exchanges a joint report from the treasury and the federal reserve board written in the wake of the 1987 crash states that t here is sufe cient possibility that at some point sros self regulatory organizations might establish margins that were inconsistent enough to present market problems or set them at levels that might present potential costs to other parties that regulatory approval should be established in all markets 1

dealer liquidity in an auction market evidence from the london stock exchange we analyse the trade characteristics and market conditions which determine the market share of a continuous auction trading system at the london stock exchange where a network of broker dealer firms is also available for trade we show that execution and information risks govern the choice of execution venue further we uncover strong commonality in the market share of the order book across stocks and find that variables proxying for market wide liquidity and informational risks also affect the choice of trading venue our results suggest that competing off book liquidity suppliers voluntarily perform at least some of the stabilisation functions normally assigned to designated market makers

the trading profits of soes bandits1 abstract soes bandits are individual investors who use nasdaq s small order execution system soes for day trading their average profit per trade is small but they trade dozens or hundreds of times per week bandits usually establish a position before most market makers have updated their quotes and lay off the position at favorable prices through instinet or selectnet it is noteworthy that they trade profitably with market makers despite having less information bandits keep the profits and bear the losses from their trades thus they have greater incentives to trade well than the employees of market making firms

real business cycles in this paper we demonstrate how certain very ordinary economic principles lead maximizing individuals to choose consumption production plans that display many of the characteristics commonly associated with business cycles our explanation is entirely consistent with i rational expectations ii complete current information iii stable preferences iv no technological change v no long lived commodities vi no frictions or adjustment costs vii no government viii no money and ix no serial dependence in the stochastic elements of the environment we also provide a completely worked out example of the type of artificial economy we have in mind the time series properties of the example exhibit some major features of observed business cycles although this type of model may not be capable of explaining all of the regularities in actual business cycles we believe that it provides a useful well defined benchmark for assessing the relative importance of factors e g monetary disturbances

microstructure and ambiguity a goal for stock exchanges is to increase participation by firms and investors we show how specific features of the microstructure can reduce perceived ambiguity and induce participation by both investors and issuers we develop a model with sophisticated traders who we view as expected utility maximizers with rational expectations and unsophisticated traders who we view as rational traders facing ambiguity about the payoffs to participating in the market we show how designing markets to reduce ambiguity can benefit investors through greater liquidity exchanges through greater volume and issuing firms through a lower cost of capital

technical analysis and liquidity provision the apparent conflict between the level of resources dedicated to technical analysis by practitioners and academic theories of market efficiency is a long standing puzzle we explore a previously unexamined feature of technical analysis namely its relation to liquidity provision we demonstrate that support and resistance levels coincide with peaks in depth on the limit order book and moving average forecasts reveal information about the relative position of depth on the book furthermore we show that these relationships stem from technical rules locating depth already in place on the limit order book copyright 2004 oxford university press