Order Submission Decisions and Market Performance under Different Trading Mechanisms

ABSTRACT This study empirically investigates the relationship among trading arrangements, order submission decisions, and market performance. We analyze investors' placement decisions and their impact on market volatility as well as liquidity under different trading frequencies. Extending beyond the scope of microstructure theoretical papers, this study focuses on whether transaction uncertainty and asymmetric information affect traders' order placement strategies. The findings indicate that traders tend to place higher (lower) reservation buy (sell) prices to cope with transaction uncertainty under a less continuous-like market with more severe problem of asymmetric information. In particular, small traders place higher reservation prices in a less continuous market than in a more continuous-like market; this may help absorb incoming orders from the counterpart side, and thus, the market becomes more liquid and less volatile. JEL classification: G14, G18 Keywords: Trading frequency; Transaction uncertainty; Investor's order placement; Market performance 1. INTRODUCTION The literature on rational expectations suggests that prices aggregate information efficiently when trading is organized as an auction with large numbers of traders. However, most of the financial markets around the world are not organized as auction markets; instead, they conduct a continuous market with or without a dealer system. Moreover, recent theoretical and empirical researches on market microstructure document that institutional arrangements have important effects on the formation of prices. Therefore, it is important for policy makers to understand how trading mechanisms affect stock price behavior. A crucial role of trading arrangements is to transform the demands of investors into realized trades. Trading strategy is an important decision that investors need to make in addition to investment decision. Traders must decide whether to place market orders or limit orders, and what should be the quoted prices in the case of limit orders. On the one hand, traders want their orders to be executed, and on the other hand, they do not want to buy too high or sell too low. An important feature of the price formation is that it relies not only on trading mechanisms, but also upon order submission strategies. Although order submission decision is of paramount importance, the issue of order placement on price behavior under different trading designs has received little attention in empirical literature. The relative performance of continuous markets and call markets has long been an interesting issue. Kyle [7], Pagano and Roell [11], Madhavan [10] and Schnitzlein [12] examined the issue from a theoretical aspect. These studies suggested that call market enhance market performance under asymmetric information despite the utilization of very different approaches to model the formidably complicated interactions in order placement and alternative trading designs. Though theoretical works have incorporated order placement decisions into the comparisons of institutional arrangements, most of empirical works focused only on the impact that continuous and call markets have on market performance, thereby neglecting the role of trading strategies. For example, Amihud and Mendelson [2] compared the call system with the continuous market using the open-to-open returns and close-to-close returns of the New York Stock Exchange. They found that open-to-open returns have higher volatility than close-to-close returns. Later in 1991, they mitigated the overnight non-trading problems using data from the Tokyo Stock Exchange, and found that in terms of volatility and efficiency, a call market is not inferior to a continuous market. Lauterbach and Ungar [8] investigated the impact of the transfer of 29 stocks in the Tel-Aviv Stock Exchange from a single daily auction to a more continuous-like trading system. …