University of Wollongong Research Online University of Wollongong Thesis Collection University of Wollongong Thesis Collections 2013 Market microstructure studies: liquidity, price discovery and manipulation Ching (Jane) Chau University of Wollongong Recommended Citation Chau, Ching (Jane), Market microstructure studies: liquidity, price discovery and manipulation, Doctor of Philosophy thesis, School of Accounting and Finance, University of Wollongong, 2013. http://ro.uow.edu.au/theses/3921 Research Online is the open access institutional repository for the University of Wollongong. For further information contact the UOW Library: [email protected] MARKET MICROSTRUCTURE STUDIES: LIQUIDITY, PRICE DISCOVERY AND MANIPULATION A thesis submitted in fulfilment of the requirements for the award of the degree DOCTOR OF PHILOSOPHY From UNIVERSITY OF WOLLONGONG by Ching (Jane) Chau Bachelor of Commerce Honours (Class 1) in Accountancy School of Accounting and Finance, Faculty of Commerce Australia June 2013 1 CERTIFICATION I, Ching Chau, declare that this thesis, submitted in partial fulfilment of the requirements for the award of Doctor of Philosophy, in the School of Accounting and Finance of the Faculty of Commerce, University of Wollongong, is wholly my own work unless otherwise referenced or acknowledged. The document has not been submitted for qualifications at any other academic institution. Ching (Jane) Chau June, 2013 2 DEDICATION To the memory of my mother, Yuduo Huang (January 1944 – May 2013) To my father, who cares for my mother with his whole heart and love. 3 ACKNOWLEDGEMENTS Many people have made valuable contributions to this research. Without their support and encouragement, it would have been difficult for me to complete this thesis. I would like to take this opportunity to gratefully acknowledge those whose contributions have been instrumental in the successful completion of this thesis. First and foremost, I would like to express my sincere thanks to my supervisors, Professor Gary Tian and Dr Shiguang Ma. Their constant support, humble attitude, deep knowledge and professional advice throughout my PhD candidature have been invaluable to the completion of this thesis. I am deeply indebted to Professor Alex Frino, who introduced me to the Capital Market CRC PhD Research Program. His immense support and encouragement during the initial years of my PhD have enabled me to pursue and complete this challenging journey. I would also like to thank Professor Helen Irvine and Dr Aelee Jun for suggestions, motivation and encouragement. This research has also benefited greatly from the thoughtful insights and feedback provided by Rick Harris, Sean Foley, George Li, Angelo Aspris, Jing Gao, Andrew Lepone, Wangchun Wei, Dionigi Gerace, Bart Frijns and Aaron Gilbert. I appreciate very much the valuable input of each of them into my journey. I gratefully acknowledge financial support provided by the Capital Market Cooperative Research Centre for a four-year full scholarship. Without this 4 financial support I would have been unable to help my brother with study and my mother with hospital expenses. I also thank the Securities Industry Research Centre of Australia (SIRCA) for providing the data used in this thesis. A special thank you goes to my family and friends. I am especially grateful to Noeline Wiggins for her love and wholehearted support. I appreciate Xinjun Wang for his regular C# programming help and for his warmth and friendliness during my PhD process. Finally, I have dedicated this thesis to my parents who have been a constant source of encouragement. 5 SYNOPSIS This thesis offers an original way to examine three specific issues in market microstructure: liquidity, price discovery and price manipulation. The purpose of this thesis is to provide empirical evidence on these issues of significance to exchange regulators in designing market structure. This thesis is structured with an introductory chapter, a theoretical chapter, three empirical analysis chapters and a concluding chapter. Chapter 1 discusses the importance of the study, and identifies research motivation and contributions. It also provides a brief description of the structure and functions of financial markets. Chapter 2 presents a theoretical framework of the study by looking at several key areas in market microstructure theory. Chapters 3 to 5 address three research questions relating to market structure effects on liquidity, price discovery and price manipulation, respectively. First, Chapter 3 examines the liquidity impact of market structure change from a transparent market to an anonymous market, in the trading of cross-listed stocks on both the Australian Stock Exchange (ASX) and New Zealand Stock Exchange (NZX). Results show that spreads decline, quoted depth and trading volume increase with the introduction of an anonymous market, after controlling for both stock-specific and market-wide liquidity factors. Anonymity attracts the trading of cross-listed stocks from the foreign counterparty. Chapter 4 further examines the impact of market structure change on the price 6 discovery process in the context of ASX and NZX. It finds compelling evidence that trader anonymity improves the price discovery process. Information share improves on ASX, but deteriorates on NZX, after ASX switched to anonymous trading. On the other hand, information share increases on NZX, but decreases on ASX, after NZX adopted anonymous trading. These results also add evidence to the prior literature on the choice of anonymous market by informed traders. Chapter 5 examines price manipulation with a specific reference to the impact of the trading mechanism in the context of the Hong Kong Stock Exchange (HKEx). It is found that the trading mechanism determines the techniques used to manipulate price. A new form of closing price manipulation, quote-based manipulation, is facilitated by the closing mechanism of HKEx. Closing price can be manipulated solely through quotes without trading, and hence without cost. The manipulator is able to inflate (deflate) closing prices through placing orders to buy (sell) small quantities of shares at prices higher (lower) than the prevailing market prices near the market close. 7 TABLE OF CONTENTS CHAPTER 1 INTRODUCTION ................................................................................................. 17 1.1 Background and Motivation ........................................................................ 17 1.1.1 Market Microstructure Study ................................................................. 18 1.1.2 Why Market Microstructure Matters ..................................................... 19 1.2 Purpose and Contributions .......................................................................... 21 1.3 Structure of This Thesis .............................................................................. 25 References ......................................................................................................... 27 CHAPTER 2 THEORETICAL FRAMEWORK OF THIS THESIS ........................................... 30 2.1 Introduction ................................................................................................. 30 2.2 Market Liquidity .......................................................................................... 32 2.3 Price Discovery ........................................................................................... 34 2.4 Price Manipulation ...................................................................................... 37 2.5 Summary ..................................................................................................... 41 References ......................................................................................................... 42 CHAPTER 3 IMPACT OF ANONYMITY ON LIQUIDITY IN LIMIT ORDER BOOKS: EVIDENCE FROM CROSS-LISTED STOCKS .................................................. 47 3.1 Abstract ....................................................................................................... 47 3.2 Introduction ................................................................................................. 48 3.3 Literature Review and Hypotheses .............................................................. 50 3.4 ASX versus NZX and Market Structure Change ........................................ 57 3.5 Data and Summary Statistics ....................................................................... 60 8 3.6 Research Methodology ................................................................................ 70 3.6.1 Univariate Analysis ............................................................................... 70 3.6.2 Fixed Effect Instrumental Variable 2SLS Estimation ........................... 74 3.7 Results ......................................................................................................... 80 3.7.1 Liquidity Impact of ASX Anonymity .................................................... 80 3.7.2 Liquidity Impact of NZX Anonymity.................................................... 86 3.8 Robustness Check ........................................................................................ 91 3.8.1 Length of Event Window....................................................................... 91 3.8.2 Difference-in-difference Estimation ...................................................... 98 3.9 Summary ..................................................................................................