Securities Trading: Principles and Procedures Joel Hasbrouck Joel Hasbrouck is the Kenneth G. Langone Professor of Business Administration and Finance at the Stern School of Business, New York University. Correspondence: Department of Finance, Stern School NYU, 44 West 4th St., New York, NY 10012. Email: [email protected]. Web: http://pages.stern.nyu.edu/~jhasbrou. Disclosures: I have served as a consultant, instructor, and/or advisor board member for numer- ous private and public institutions. Copyright 2021, Joel Hasbrouck. All rights reserved. Version 12c; this draft: August 30, 2021. Major edits and editions since the prior draft (STPPms12b) are indicated by a solid line in the right magin. © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §1 p. 1 [Blank Page] © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §1 p. 2 i Preface This manuscript is a set of draft teaching notes for a one-semester course entitled Principles of Securities Trading. The target audience is finance students planning careers in trading, invest- ment management, or law, and information technology students who seeking to build trading and investment systems. The exposition draws on general economic principles, with an institu- tional focus on US equity markets. The high level of institutional content underscores the realism and currency of the mate- rial. Given the speed with which markets evolve, however, it is likely (maybe even certain) that some of the details are out of date. By way of full disclosure, I’ve taught (for compensation) in the training program of a firm that engages in high frequency trading. I’m presently associated with the US CFTC as an (un- compensated) “special government employee”. I’ve served on various government and industry advisory committees. I give presentations at financial institutions for which I sometimes receive honoraria. Although these notes draw from the subject generally known as market microstructure, they certainly don’t fully cover the field. There are many important areas of academic research that are barely touched upon: the econometrics of high-frequency data; measurement of liquid- ity; liquidity risk and commonality; liquidity and asset pricing; empirical analysis of price dis- covery; and so on. These omissions reflect the priority placed on simplifying the foundations of the subject, rather than discussing all the extensions. The text is organized in parts (broad themes), chapters and sections. • Part I starts with the basics. It introduces key terms and describes the important players. It explores the floor markets (pre-21st century) and their modern descend- ants, the continuous electronic limit order markets. • Part II considers extensions and alternatives to the limit order markets: auctions, dealers and dark trading mechanisms. • Part III examines informational efficiency. Many readers will have encountered the subject in an earlier finance class. They will have absorbed the idea that the market price of the stock incorporates and fully reflects the split, the takeover announce- ment, or whatever. The present approach discusses the trading processes that makes this incorporation possible. The role of trading procedure is particularly im- portant with respect to private information, which can give rise to bid-ask spread effects, price impacts, market failures and so forth. Part III also discusses some is- sues of practical and legal importance: securities class action lawsuits and insider trading regulation. • Part IV introduces algorithmic trading. The approach is incremental, moving from complex order types to statistical models and discussion of the order splitting prob- lem. • Part V covers current topics in regulation and high frequency trading. Passages that have been significantly changed since the previous draft (STPPms12b) are indi- cated by a line in the right margin. © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §2 p. 1 ii [Blank page] © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §2 p. 2 iii Table of Contents Part I. Modern securities markets: the basics .............................................. 1 Chapter 1. Introduction ............................................................................................................................................ 2 Chapter 2. The Elements of a Securities Market: US Equities .................................................................. 5 Chapter 3. Floor Markets ....................................................................................................................................... 15 Chapter 4. Limit order markets .......................................................................................................................... 21 Chapter 5. Multiple markets ................................................................................................................................. 39 Part II. Alternatives to Limit Order Markets ............................................... 48 Chapter 6. Auctions .................................................................................................................................................. 49 Chapter 7. Dealers in public limit-order markets ........................................................................................ 68 Chapter 8. Dark Markets ........................................................................................................................................ 78 Chapter 9. Dealer markets .................................................................................................................................... 84 Part III. Information and efficiency ................................................................ 96 Chapter 10. Public Information ........................................................................................................................... 97 Chapter 11. Securities Class Action Lawsuits............................................................................................. 112 Chapter 12. Private Information ...................................................................................................................... 125 Chapter 13. Insider Trading .............................................................................................................................. 139 Part IV. The Basics of Algorithmic Trading ............................................... 150 Chapter 14. Complex Orders ............................................................................................................................. 151 Chapter 15. Transaction Cost Analysis (TCA) ............................................................................................ 158 Chapter 16. Statistical Models of Order-Price Dynamics ...................................................................... 171 Chapter 17. Order Splitting ................................................................................................................................ 178 Part V. Special Topics ....................................................................................... 185 Chapter 18. Pricing, Fees, and Rebates ......................................................................................................... 186 Chapter 19. Reg NMS ............................................................................................................................................ 194 Chapter 20. High Frequency Trading (HFT) ............................................................................................... 203 © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §3 p. 3 iv [Blank Page] © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §3 p. 4 Part I. Modern securities markets: the basics Securities markets rely on highly structured trading procedures and well-defined institutional roles. Part I introduces these institutions and procedures. This part discusses, by way of back- ground, the floor markets. It then goes on to explore the descendants of these floors, our mod- ern limit order markets. © Joel Hasbrouck, 2021. STPPms12c.docx; 2021-08-30; Part I. Chapter 1. Introduction; §4 p. 1 Introduction 2 Chapter 1. Introduction We place strong demands on our securities markets. When we plan our investments or hedge risks, we rely on market prices to tell us the value of what we currently have and the cost of what we might attempt to do. We enter the markets to trade and implement our decisions. As events unfold over time, we return to the markets to monitor our progress and revise our deci- sions. Finally, when we want to consume the gains from our investments or the hedge is no longer needed, we sell or settle the securities. In basic economics, supply and demand are usually assumed to play out in an idealized per- fectly frictionless market. Each buyer and seller is assumed to be atomistic. That is, each individ- ual is small relative to the overall market. When acting alone, each is incapable of meaningfully influencing the price. Each trader willingly expresses her true preferences: when she is asked “How much would you buy if the price were x?,” for example, she answers honestly. (It does not occur to her to bluff or feign a weaker demand to obtain a lower price.) The buyers collectively define the demand curve (seeking to buy much at low prices, and little