DS0801 -

Price formation In Financial MarketS – PIMS

Price formation In Financial MarketS (PIMS)

The purpose of this research is to further our understanding of the extent to which gains from trade can be reaped in financial markets. This investigation requires looking inside the black box of markets’ organization to understand the way they operate and how this way influences the decisions of the various participants and the equilibrium outcome.

Objectives

Designing the organization of financial markets thus implies defining the microstructure of the market, i.e., the trading and aggregation rules. Rules are often imperfect, in particular in the rapidly evolving environment of financial markets. As a result, designing a specific market structure might generate various frictions, which might interplay with the beliefs, with the strategic interactions, or with the cognitive biases of market participants (e.g., investors, managers, or financial intermediaries). The objective of the present research project is to study i) the consequences of these frictions on the prices, and thus on market quality and welfare, ii) how different market arrangements worsen or mitigate these problems, and iii) which public policies could be put in place to improve the functioning of markets.

The questions I will address belong to broad issues related to the influence of the trading rules on the price formation, market liquidity and stability, or to whether risks are efficiently shared and assets are correctly priced. My project is at the crossing of fields, namely, market microstructure, asset pricing, behavioural finance, and corporate finance. To achieve these objectives, my scientific approach is firmly grounded on theoretical, experimental, and empirical bases.

To facilitate price discovery, Euronext Paris has always relied on a transparent pre- opening phase and on a call auction to open continuous markets. We show that slow brokers submit orders very early, and most of them are executed within the day. In contrast, fast prop traders or dedicated liquidity providers only participate in the last half-hour. Interestingly the pre-opening activity of slow brokers is strongly related to the price discovery process across trading platforms.

Using data for the European Treasury bond market, we find evidence that funding illiquidity shocks affect bond market illiquidity and of a weaker, but significant, reverse feedback effect. We also find that, in the cross-section, the responses of individual bonds’ market illiquidity to funding illiquidity shocks increase with bond duration, the credit risk of the issuer, and with haircuts.

We design an experiment that closely emulates and tests the standard model of complete competitive markets. Aggregated elicited supply and demand curves cross at the expected dividend when there is no aggregate risk. In contradiction with theory, individual participants frequently make choices that violate first order stochastic dominance. We propose a random choice model which reconciles the above mentioned findings and is also consistent with additional features of the data, such as, e.g., large mistakes being less frequent than smaller ones.

In the long run, learning induces the market to converge to the unique no bubble equilibrium. However, learning initially increases traders’ propensity to speculate. In the short run, more experienced traders thus create more bubbles. An experiment shows that bubbles are very pervasive despite the fact that subjects have become experienced. Our estimation of the EWA model also indicates that learning is at work.

This research agenda is in part spurred by the recent public and regulatory concern on systemic risk, on market stability, and on market integrity induced by the recent phenomenal increase in trading speed capacities of financial institutions and by changes in the regulatory landscape. Thanks to my work on algorithmic trading initiated in 2008 (before it became a concern for the public and the regulators), high-frequency-trading and market fragmentation now belong to my areas of expertise. Most of the individual projects that I will describe below directly aim at tackling issues of concern for regulators. My focus on European Equity and Treasury markets may lead to conclusions or policy implications that may be more relevant to European regulators and market authorities than the outcome of studies dedicated to U.S. markets.
This research project is also prospective. My aim is to bridge the gaps between asset pricing and market microstructure, market microstructure and corporate finance, market microstructure and banking, or behavioural finance and asset pricing.

1. www.tse-fr.eu/fr/publications/learning-speculative- bubbles-experiment
2. www.tse-fr.eu/fr/publications/funding-constraints- and-market-illiquidity-european-treasury-bond-market
3. www.tse-fr.eu/fr/publications/asset-pricing-and- risk-sharing-complete-market-experimental-investigation
4. papers.ssrn.com/sol3/papers.cfm

The purpose of this research is to further our understanding of the extent to which gains from trade can be reaped in financial markets. This investigation requires looking inside the black box of markets’ organization to understand the way they operate and how this way influences the decisions of the various participants and the equilibrium outcome.
Financial markets are supposed to fulfil three main functions: the pricing of assets thanks to the equilibrium price discovery, an efficient allocation of risks by enabling participants to realize mutually beneficial trades, and the financing of the economy by easing the access of firms and sovereign institutions to scarce resources. The capacity of financial markets to fulfil these functions and their efficient functioning may however be hindered by various frictions. Their organization indeed requires an institutionalization process, by which a precise infrastructure would be designed, and trading rules defined. First, a trading venue has to define a market model (i.e., trading rules). Second, the trading environment may evolve, for instance due to technological innovations, such as the development of High--Frequency--Trading (hereafter HFT), or financial innovations, like Exchange Traded Funds replicating indexes like the CAC40, the Eurostoxx 50 or the S&P500. Finally, there may also be changes in regulation. The RegNMS in the U.S. or the Markets in Financial Instruments Directive (hereafter MiFID) in Europe, both implemented in 2007, have reshaped the competitive landscape of Equity markets by allowing market fragmentation.
Designing the organization of financial markets thus implies defining the microstructure of the market, i.e., the trading and aggregation rules. Rules are often imperfect, in particular in the rapidly evolving environment of financial markets. As a result, designing a specific market structure might generate various frictions, which might interplay with the beliefs, with the strategic interactions, or with the cognitive biases of market participants (e.g., investors, managers, or financial intermediaries). The objective of the present research project is to study i) the consequences of these frictions on the prices, and thus on market quality and welfare, ii) how different market arrangements worsen or mitigate these problems, and iii) which public policies could be put in place to improve the functioning of markets.
The questions I will address belong to broad issues related to the influence of the trading rules on the price formation, market liquidity and stability, or to whether risks are efficiently shared and assets are correctly priced. My project is at the crossing of fields, namely, market microstructure, asset pricing, behavioural finance, and corporate finance. To achieve these objectives, my scientific approach is firmly grounded on theoretical, experimental, and empirical bases.
This research agenda is in part spurred by the recent public and regulatory concern on systemic risk, on market stability, and on market integrity induced by the recent phenomenal increase in trading speed capacities of financial institutions and by changes in the regulatory landscape. Thanks to my work on algorithmic trading initiated in 2008 (before it became a concern for the public and the regulators), high-frequency-trading and market fragmentation now belong to my areas of expertise. Most of the individual projects that I will describe below directly aim at tackling issues of concern for regulators. My focus on European Equity and Treasury markets may lead to conclusions or policy implications that may be more relevant to European regulators and market authorities than the outcome of studies dedicated to U.S. markets.
This research project is also prospective. My aim is to bridge the gaps between asset pricing and market microstructure, market microstructure and corporate finance, market microstructure and banking, or behavioural finance and asset pricing.

Project coordinator

Madame Sophie Moinas (FONDATION JEAN JACQUES LAFFONT)

The author of this summary is the project coordinator, who is responsible for the content of this summary. The ANR declines any responsibility as for its contents.

Partner

FONDATION JEAN JACQUES LAFFONT

Help of the ANR 258,552 euros
Beginning and duration of the scientific project: September 2016 - 48 Months

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