Table Of ContentZicklin School of Business Financial Markets Series
Robert A. Schwartz
John Aidan Byrne
Lauren Wheatley Editors
The Economic
Function
of a Stock
Exchange
The Economic Function of a Stock Exchange
Zicklin School of Business Financial
Markets Series
Robert A. Schwartz, Editor
ZicklinSchoolofBusiness
BaruchCollege/CUNY
NewYork,NY,USA
Forothertitlespublishedinthisseries,goto
www.springer.com/series/7133
(cid:129)
Robert A. Schwartz John Aidan Byrne
Lauren Wheatley
Editors
The Economic Function
of a Stock Exchange
Editors
RobertA.Schwartz JohnAidanByrne
ZicklinSchoolofBusiness NewYork,NY
BaruchCollege/CUNY USA
NewYork,NY
USA
LaurenWheatley
ZicklinSchoolofBusiness
BaruchCollege/CUNY
NewYork,NY
USA
ISBN978-3-319-10349-5 e-ISBN978-3-319-10350-1
DOI10.1007/978-3-319-10350-1
SpringerChamHeidelbergNewYorkDordrechtLondon
LibraryofCongressControlNumber:2014954251
©SpringerInternationalPublishingSwitzerland2015
Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpart
of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations,
recitation,broadcasting,reproductiononmicrofilmsorinanyotherphysicalway,andtransmissionor
informationstorageandretrieval,electronicadaptation,computersoftware,orbysimilarordissimilar
methodologynowknownorhereafterdeveloped.Exemptedfromthislegalreservationarebriefexcerpts
inconnectionwithreviewsorscholarlyanalysisormaterialsuppliedspecificallyforthepurposeofbeing
enteredandexecutedonacomputersystem,forexclusiveusebythepurchaserofthework.Duplicationof
this publication or parts thereof is permitted only under the provisions of the Copyright Law of the
Publisher'slocation,initscurrentversion,andpermissionforusemustalwaysbeobtainedfromSpringer.
PermissionsforusemaybeobtainedthroughRightsLinkattheCopyrightClearanceCenter.Violationsare
liabletoprosecutionundertherespectiveCopyrightLaw.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are exempt
fromtherelevantprotectivelawsandregulationsandthereforefreeforgeneraluse.
While the advice and information in this book are believed to be true and accurate at the date of
publication,neithertheauthorsnortheeditorsnorthepublishercanacceptanylegalresponsibilityfor
anyerrorsoromissionsthatmaybemade.Thepublishermakesnowarranty,expressorimplied,with
respecttothematerialcontainedherein.
Printedonacid-freepaper
SpringerispartofSpringerScience+BusinessMedia(www.springer.com)
Price Discovery: The Economic Function
of a Stock Exchange1
We all know a stock exchange when we see it. The challenge is offering a
clear and concise definition of a stock exchange. According to Webster’s
Dictionary, a stock exchange is a place where security trading is conducted
onanorganizedsystem.Armedwiththisinformation(andnothavingaclue
what Webster was telling us!), we googled “organized system.” We came
uponacoupleofentriesdealingwithhealthandthelike,atthetopwas“book
binding.”Sothat’sit—astockexchangeisaplacewherewebindthebooks.
It sure beats cooking them!
AfurthersearchwithGoogleproducedasizableamountofdescriptionon
astockexchange,specificallywiththisinsight:anexchangeisanassociation
of stock brokers who meet and transact business according to recognized
formsandregulations.Wecancertainlydobetterthanthiswasourimmedi-
ate thought.
Abetterapproachtodefininganexchange,weconcluded,wastofocuson
the economic service that the institution provides. And that brings us to the
titleofthispaper:Whatistheeconomicfunctionofastockexchange?Being
Baruch professors, we offer the following multiple choice question:
The economic function of a stock exchange is to:
1. Handle transactions with reasonable speed at reasonable cost (this one
obviously has to be correct).
2. Find the two sides of a trade (well, quantity discovery does matter).
3. Produce the price (price discovery certainly is important).
1This chapter is a slightly amended paper of the same title by Nasli Sila Alan and Robert
A.Schwartz,publishedintheJournalofPortfolioManagement,Fall2013.Thepaperwas
developed from Schwartz’s Opening Comments at this 2011 Baruch conference in
NewYorkCity.ReprintedwithpermissionfromtheJournalofPortfolioManagement.
v
vi The Economic Function of a Stock Exchange
4. Facilitatecapitalraisingintheprimarymarket(itisuncontestablethata
vibrantIPOmarketisvitallycriticalforacountry’seconomicgrowth).
5. All of the above (this one drives our students crazy).
The answer? Number 5, of course, “All of the above.”
Of course, this is not the kind of pithy definition we were searching for.
Afterabitmoreheadscratching,wedecidedtodrilldownonjustoneofthe
answers—Number3,“Producetheprice.”Andbingo,wehadourdefinition:
an exchange is the venue where share prices for listed securities are discov-
ered. In this paper, we delve into some of the economic thinking that
underlies this definition.
PRICE DISCOVERY IS A PUBLIC GOOD
We start by considering the economic importance of an exchange pro-
duced price. Given the multiple uses to which a discovered price is put,
efficient price discovery is critically important, not just to those who partic-
ipate in a trade but to a far more extensive set of people. An exchange
produced price is used for:
(cid:129) Marking-to-market
(cid:129) Derivative pricing
(cid:129) Valuations of mutual fund cash flow
(cid:129) Estate valuations
(cid:129) Dark pool pricing
Because the beneficiaries include a wide range of people who are not
participating in the transactions that establish a price, an economist would
refertoanexchangeproducedpriceasapublicgood.Aclassicexampleofa
public good is the lighthouse in a harbor. Any ship passing in the night can
see the lighthouse. Who among us would suggest that the light in the
lighthouse be selectively shut off? You simply do not tell a ship’s captain,
“No, youarenotallowedtoseethelight becauseyoudidnotpayto seeit.”
The lighthouse is standing there on a rock, and all passing ships are con-
sumers of the service that it provides but does not directly charge for. The
lighthouse is a public good.
We like the lighthouse image because an exchange-discovered price
shines light on the value of shares for the broad public.2 The idea is the
same—a broad spectrum of market participants looking at an exchange
2For earlier mention of the lighthouse image in the context of price discovery, see Robert
A. Schwartz, “Dark Pools and Fragmented Markets,” World Federation of Exchanges,
2009AnnualReportandStatistics.
Price Discovery: The Economic Function of a Stock Exchange vii
produced price, and a ship’s captain spotting a lighthouse, all gain valuable
information without directly paying for it.3 It is extremely important to
remember this. So why hasn’t price discovery received more attention
given its critical role as a public good? Of course, there is some analysis in
theacademicliteratureandabitofhandwavingonthetopicaswell,andthe
term “price discovery” does come up at times in regulatory discussions and
documents.Nevertheless,theconceptofanexchange-producedpricebeinga
public good receives woefully inadequate attention in public debates about
market structure.
THE COMPLEXITY OF PRICE DISCOVERY
How difficult is price discovery, one might enquire? For a simple reason,
price discovery is complicated and should not be taken for granted. We all
talk about fundamental values, and about prices at times decoupling from
fundamentalvalues,butstocksdonothavefundamentalvalues.Howcanwe
say this? We will answer this question with a question: Do people agree in
their stockanalyses?Consider this:About 2:00pmonApril 4, 2013,Apple
shares traded at $429.38. Did all investors at that time believe that Apple
shares were worth $429.38 exactly? Before we answer let us first explain.
Clearly,if weall agree abouttheinputs of amodel,we willall get thesame
answersandtherebyreachthesameconclusions.Butdoweagreeaboutthe
inputs? Do we all even use the same models? What happens if we do not?
The academic term that characterizes total agreement is “homogeneous
expectations.” If investors do not have homogeneous expectations, the term
usedis“divergentexpectations.”So,whichisit,homogeneousexpectations
or divergent expectations? We think the latter (note that any disagreement
about this would only serve to support our point). Of course, homogeneous
expectations is a useful assumption for much modeling (e.g., the Capital
Asset Pricing Model). Moreover, some academicians believe that the
assumption is not unrealistic (identically informed and rational players, the
argument goes, should all reach the same conclusions). But evidence is
widespread that expectations are divergent. We hear substantial debate and
disagreementamonginvestors,commentators,andstockanalystsaboutshare
values.Weattributethistotheenormoussize,complexity,inexactitude,and
incompleteness of the information set. Accordingly, the divergent
3Stockpricedataare,ofcourse,soldbyexchangesandboughtbycustomerswhowantinstant
delivery,alongwithacademicianswhousetradeandquotedataforacademicresearch.
viii The Economic Function of a Stock Exchange
expectationsenvironmentistheonethatwewishtooperatewithinandbetter
understand (see Davis et al. (2007) for further discussion).
Now, if people disagree about a stock’s share value, wherein lies its
fundamental value? Answer: nowhere. In a divergent expectations world,
the market is there to find, not fundamental values, but equilibrium prices.
Thatis,priceswhichharmonizethedesiresofacontinuumofdisparatebulls
andbearstoholdshares.Findingthesepricesiswhatastockexchangedoes,
and fulfilling this function is not a simple matter.
MARKET STRUCTURE MATTERS
Recognizingthatthequalityofpricediscoveryisimportant,onemightstill
questionwhetherornotqualitydependsonthearchitectureofamarketplace.
The answer is clear: the efficiency with which prices are discovered very
much depends on the procedures, rules, and regulations that govern how
orders are submitted, brought together, and turned into trades. For instance,
the priority rules of order execution (price, time, size, etc.), the temporal
consolidation of orders in call auction trading, the use of stock specific
trading halts and across theboard circuit breakers, all determinehoworders
interact. In so doing, all these establish trades and transaction prices. Three
recent enactments by the Securities and Exchange Commission, along with
remarkable technological developments, have intensified inter-market com-
petition.TheseenactmentsweretheOrderHandlingRulesof1997;Regula-
tion Alternative Trading Systems of 1998, and Regulation NMS (which
includes the trade-through rule) fully implemented by 2007. This combina-
tionofregulationsandtechnologyhasfragmentedthemarketplace,primarily
for NYSE issues. The order flow is integrated differently in a fragmented
marketplaceand,thus,pricediscoverycanbeaffected.Inalatersection,we
consider the effect that NASDAQ’s opening and closing calls (instituted in
2004) have had on price volatility at market openings and closings.
Market structure change, whether caused by technology developments,
regulation,and/or competitivepressures,canbeassessedin termsofmarket
characteristicssuchastradingcosts(e.g.,commissions,spreads,andmarket
impact costs), consolidation/fragmentation of the order flow, pre- and post-
trade transparency, market robustness/fragility, fairness, and the quality of
price discovery. The quality of price discovery relates to each of its pre-
decessorsonthelist:trading atdisequilibriumpricesis atrading cost; noisy
price discovery obfuscates market transparency; price discovery is more apt
to spin out of control in a fragile marketplace; and poorly discovered prices
arefairneithertotraderswhoareactiveinthemarketnortothebroadmarket
Price Discovery: The Economic Function of a Stock Exchange ix
that uses exchange prices for a spectrum of non-trading purposes (As we
have noted, an exchange produced price is a public good).
We suggest that good quality price discovery be placed high on the
regulatory priority list. With a sharper focus on price discovery, the other
market characteristics should more readily fall into place. However, being
high on the list comes with a necessary precondition that the objective be
operational, which leads to a very key question: How can we assess the
quality of price discovery? What can be used as a benchmark?
INFERRING THE QUALITY OF PRICE
DISCOVERY
OnlyGodknowswhattheequilibriumpricemaybe,meremortalscannot
see it. Unfortunately, because we are not able to quantify the deviations of
actualpricesfromunobservableequilibriumvalues,thereisatendencynotto
study market quality in terms of the efficiency of price discovery.
Unobservability is indeed a debilitating reality from both an academic and
a regulatory perspective. But all is not lost! We can assess the accuracy of
price discovery by focusing on very short-period, intraday price volatility.
Theefficiencyofpricediscoverycanbeinferredfromthelevelofintraday
price volatility. That’s because intraday volatility is accentuated by micro-
structure factors, most notably bid-ask spreads, market impact, and price
discovery noise. Critically, the accentuation is too large to be explained
entirely by spreads and market impact, especially in the neighborhood of
market openings and closings. The dominant factor, in our opinion, is price
discovery noise, particularly at market openings. This is at a time when,
following the advent of overnight news, finding “the price” is most chal-
lenged on a daily basis.
ItiswellestablishedthatintradayvolatilityfollowsaU-shapedpattern.In
fact, the U-shape is so severe that, in the opening and closing minutes,
volatility shoots up sharply and the intraday pattern is more stapled-shaped
thanU-shaped.Asnoted,weattributetheopeningspiketothecomplexityof
price discovery (while the closing spike is largely a consequence of traders
trying to “get the job done” before the market closes).
Westresstheimportanceofanalyzingintradayvolatilityanditsimplications
forpricediscoverywhenamarketisunderstress.Foritisatatimesuchasthis
thatthecomplexitiesofpricediscoveryarebroughttolight.Inrelativelycalm
periods, price discovery is not as big an issue, and the quality of a trading
systemisnotparticularlychallenged.Wehoneinonstressbyfocusingonthe
first half hour of trading and, in the section after the next that follows, by
showing the price record for a stock (Disney) that, on a specific day (August
10,2011),exhibitedextraordinarilyhighfirsthalf-hourvolatility.
