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Electronic Call Market Trading Nicholas Economides and Robert A VOLUME 21 NUMBER 3 SPRING 1995 Electronic Call Market Trading Nicholas Economides and Robert A. Schwartz Hidden Limit Orders on the NYSE Thomas H.Mclnish and Robert A. Wood Benchmark Orthogonality Properties David E. Tierney and Jgery K Bailey - Equity Style ClassXcations Jon A. Christophmon "'Equity Style Classi6ications": Comment Charles A. Trzn'nka Corporate Governance: There's Danger in New Orthodoxies Bevis Longstreth Industry and Country EfZ'ects in International Stock Returns StmL. Heston and K. Ceert Routuenhont Currency Risk in International Portfolios: How Satisfying is Optimal Hedging? Grant W Gardner and Thieny Wuilloud Fundamental Analysis, Stock Prices, and the Demise of Miniscribe Corporation Philip D. Drake and John W Peavy, LLI Market Timing Can Work in the Real World Glen A. Lmm,Jt., and Gregory D. Wozniak "Market Timing Can Work in the Real World": Comment Joe Brocato and ER. Chandy Testing PSR Filters with the Stochastic Dominance Approach Tung Liang Liao and Peter Shyan-Rong Chou Diverfication Benefits for Investors in Real Estate Susan Hudson- Wonand Bernard L. Elbaum A PUBLICATION OF INSTITUTIONAL INVESTOR, INC. Electronic Call Market Trading Let competition increase @n'ency. Nicholas Economides and Robert A. Schwartz ince Toronto became the first stock exchange to computerize its execution system in 1977, electronic trading has been instituted in Tokyo S(1 982), Paris (1986), Australia (1990), Germany (1991). Israel (1991), Mexico (1993). Switzerland (1995), and elsewhere around the globe. Quite likely, by the year 2000, floor trading will be totally eliminat- ed in Europe, predominantly in favor of electronic con- tinuous markets. Some of the new electronic systems are call mar- kets, however, including the Tel Aviv StockExchange, the Paris Bourse (for thinner issues), and the Bolsa Mexicana's intermediate market. In this article, we con- sider the call market as an alternative trading environ- ment that is particularly suitable to computerization. Recognizing the combined power of the com- puter and the call, several proprietary trading systems have introduced electronic batched trading in the United States. The Arizona Stock Exchange (AZX) instituted an electronic call market in Spring 1992. NICHOLAS ECONOMIDES it Previously, electronic crossing networks (a form of call professor of economics at the Stern market trading) had been established by Reuten School of Business of New YO* (Instinet's "Crossing Network," 1987, Jaes (ITG's univerrity (NY 10012). POSIT, 1987, and the New York Stock Exchange (its afier-hours system. Crossing Networks I and 11, 1990). ROBERT k SCHWARTZ is Additionally, a British proprietary system, TradePoint, profeuor of finance and economics plans to inaugurate an electronic market that includes and Yhchi ticulty fdow at the both call and continuous trading in 1995. Stan School of Business of New Scant attention has been given to incorporating York University (NY 10012). an electronic call into a major market center so as to SPRING 1995 provide investors with an alternative trading environ- orders that are not disclosed to other participants. At ment (see Cohen and Schwartz [1989]). The innova- the call, orden are arrayed by price and cumulated hm tion to market structure that we propose is incorporation the highest bid to the lowest bid for buy orders and of an electronic call market into a continuous trading system tbm the lowest ask to the highest ask for sell orders. such as the New York Stock Exchange's agencylauc- The cumulated orden are matched against each other, tion market or Nasdaq's competitive dealer market. and the clearing price is determined. A limitation of Specifically, we propose that the electronic call the sealed bid-ask auction is that it hides orders that be held three times per day: to open the market, to some participants may wish to expose and that others close the market, and once during the trading day. would like to see. Incorporating an electronic call into the continuous A crossing network also batches orders, but market will increase the efficiency of the U.S. markets instead of determining the price within the batching and enable them to compete more effectively in the process, it uses a price that has been set elsewhere. For global market for order flow. example, POSIT, Instinet, and the two NYSE cross- ing network all cross orders at prices that have been ALTERNATIVE CAU MARKET STRUCTURES established in the primary market centers. Instinet and the NYSE's afler-hours systems use closing prices, The essence of call market trading is that orders while POSITS intraday crosses use current intraday are batched together for simultaneous execution, in a prices. For this reason a crossing network cannot be single multilateral trade, at a prespecified time, and at a used as a stand-alone system - it does not itself pro- single price - the value that best equates the aggregat- duce a clearing price. ed buys and sells. Buys at this price and higher, and selIs Cdmarket trading may also be structured as an at this price and lower, generally execute. open order book auction. This approach is used as the If, because of quantity discontinuities, an exact opening procedure in most electronic continuous mar- match between aggregate buys and sells does not exist kets. For example, the opening procedures for at any price, buy orders placed at the clearing price do Toronto's CATS, Tokyo's CORES, Paris's CAC, and not execute in Ml (if buys exceed sells), or sells do not Australia's SEATS are structured as open order book execute in fid (ifsells exceed buys). Time priority (the auctions. So too is the Arizona Stock Exchange's elec- orders placed first execute first) or pro rata execution tronic call market. (an equal percentage of each order executes) is com- Aggregated buy and sell quantities at each price monly used to determine which orders to execute are displayed once they have been received by the mar- among those that have been placed at the lowest exe- ket, and all participants can watch the market as it cutable bid (if buys exceed sells) or at the highest exe- forms. Orders are continuously aggregated and sorted, cutable ask (if sells exceed buys). and the price that would be struck if the call were held Call markets may be structured in different at that moment is updated and displayed. We consider ways, most notably with respect to the mechanism the open book electronic call the most suitable transactions used for determining the clearing price. An auction network for a major market center. where participants are physically present is typically organized as a price scan auction. In a price scan auction, ATTRIBUTES OF THE CALL an auctioneer announces tentative prices and partici- pants respond with their buy/sell desires. The price A securities market should be designed with search procedure continues until the value that best regard to two objectives: reduction of the costs of trans- balances the buy and sell orders is found. Examples of acting for the participants in a trade, and enhancement this type of call include art auctions, tulip bulb auc- of the accuracy of price discovery for the broad market tions, the old call market system of the Paris Bourse (if (see Schreiber and Schwarez [1986]). With these ends la de),and the system currently used to open trading in mind, we now consider the call market with respect on the NYSE. to issues concerning the need for immediacy, the use of An alternative to the price scan system is the electronic technology, order handling, information rev- sealed bid auction used by the U.S. Treasury. In gener- elation, market transparency, consolidation of order al, in a sealed bid/ask auction, participants submit priced flow, and the problem of he-riding. While many of SPRING 1995 THE JOURNAL OP PORTFOLIO MANAGEMEm 11 our comments hold for call markets in general, our dis- 50% indicated that they regularly or frequently take cussion for the most part applies to the open book elec- more than one day to execute a large order broken into tronic call. smaller pieces. Immediacy Use of Electronic Technology A perceived limitation of call market trading is Non-electronic calls do not fully exploit the that it does not allow for continuous access to the mar- potential of call market trading. With computerization, ket. Alternatively stated, continuous trading is deemed participants can see the order flow and interact with the desirable because participants can transact whenever system on a real-time basis, entering their orders while they choose during a trading session. It has been wide- the computer broadcasts the orders and indicated clear- ly believed that traders do demand transactional imme- ing prices. At the moment of the call, the computer diacy, and our securities trading systems are for the finds the single price for each stock that clears the mar- most part based on the principle of continuous trading. ket, and market clearing prices for all issues can be In this regard, dealers and specialists as suppliers of determined simultaneously. immediacy have been considered essential to the oper- Simultaneous clearing enables a customer's buy ations of the market. order for XYZ shares to depend on the price of ABC These assumptions should be questioned in shares, the value of an aggregate market index, and/or three respects. First, the demand for immediacy is in simply the number of XYZ shares offered for sale at the part endogenous to the continuous market. Once a customer's price or better.' This contrasts with the old participant decides to seek a trade, that individual might non-electronic calls of Europe, where the markets for wish to trade quickly in order to gain anonymity and to aerent shares had to be called sequentially, and the avoid having his or her order hnt-run.
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