Trading Costs and Electronic Markets

This reading explains the implicit and explicit costs of trading as well as widely used methods for estimating transaction costs. The reading also describes developments in electronic trading, the main types of electronic traders, their needs for speed and ways in which they trade. Electronic trading benefits investors through lower transaction costs and greater efficiencies but also introduces systemic risks and the need to closely monitor markets for abusive trading practices. Appropriate market governance and regulatory policies will help reduce the likelihood of events such as the 2010 Flash Crash. The reading’s main points include:

• Dealers provide liquidity to buyers and sellers when they take the other side of a trade if no other willing traders are present.

• The bid–ask spread is the difference between the bid and the ask prices. The effective spread is two times the difference between the trade price and the midquote price before the trade occurred. The effective spread is a poor estimate of actual transaction costs when large orders have been filled in many parts over time or when small orders receive price improvement.

• Transaction costs include explicit costs and implicit costs. Explicit costs are the direct costs of trading. They include broker commissions, transaction taxes, stamp duties, and exchange fees. Implicit costs include indirect costs, such as the impact of the trade on the price received. The bid–ask spread, market impact, delay, and unfilled trades all contribute to implicit trading costs.

• The implementation shortfall method measures the total cost of implementing an investment decision by capturing all explicit and implicit trading costs. It includes the market impact costs, delay costs, as well as opportunity costs.

• The VWAP method of estimating transaction costs compares average fill prices to average market prices during a period surrounding the trade. It tends to produce lower transaction cost estimates than does implementation shortfall because it often does not measure the market impact of an order well.

• Markets have become increasingly fragmented as venues trading the same instruments have proliferated. Trading in any given instrument now occurs in multiple venues.

• The advantages of electronic trading systems include cost and operational efficiencies, lack of human bias, extraordinarily fast speed, and infinite span and scope of attention.

• Latency is the elapsed time between the occurrence of an event and a subsequent action that depends on that event. Traders use fast communication systems and fast computer systems to minimize latency to execute their strategies faster than others.

• Hidden orders, quote leapfrogging, flickering quotes, and the use of machine learning to support trading strategies commonly are found in electronic markets.

• Traders commonly use advanced order types, trading tactics, and algorithms in electronic markets.

• Electronic trading has benefited investors through greater trade process efficiencies and reduced transaction costs. At the same time, electronic trading has increased systemic risks.

• Examples of systemic risks posed by electronic traders include: runaway algorithms that produce streams of unintended orders caused by programming mistakes, fat finger errors that occur when a manual trader submits a larger order than intended, overlarge orders that demand more liquidity than the market can provide, and malevolent order streams created deliberately to disrupt the markets.

• Real-time surveillance of markets often can detect order front running and various market manipulation strategies.

• Market manipulators use such improper activities as trading for market impact, rumormongering, wash trading, and spoofing to further their schemes.

• Market manipulation strategies include bluffing, squeezing, cornering, and gunning.