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One difficulty relates to exactly what information is observable. For the purpose of this discussion we will assume that a market is said to be transparent if the order flow can be observed.
Note the word "Order Flow". The order flow information can be very complicated since we need to take the following into account:
- The size and direction of the orders
- The timing of the orders
- The form of orders for example: a limited or a market order
- Who submit the orders?
In deciding whether a market is transparent we also need to know who can observe the information. Is the information observable only to price-setting agents, to those on the floor of the exchange, to traders who submit orders or to potential traders at large?
The issues above are very important because the information available in the trading process can affect the strategies of market participants.
Charles Schumer, the third-ranking Democrat in the U.S senate, ask the Securities and Exchange Commission to ban so-called flash orders for stocks, saying they give high-speed traders an unfair advantage.
"This kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system, where a privileged group of insiders receives preferential treatment," Schumer wrote in the letter.
According to Bob Greifeld, chief executive of NASDAQ. "Flash orders are but one symptom of the current evolving market structure. We have a unique opportunity at this time to take a hard look at dark order types and the underlying market structure issues that do not support public price formation. These include flash orders, internalised orders, enhanced liquidity providers, Block Talk orders and dark pools."
Market participant's strategies will depend on the transparency of the market and the market equilibrium is directly related to the degree of transparency.
The question we need to ask ourselves is: "What is the optimal level of transparency?"
Many researches have been done in this area.
Madhaven in 1992 analyses how transparency of orders affects market behavior and viability when order flow information is observable to both price setters and traders.
Pagano and Roell in 1993 consider how transparency of orders to price setting agents affects the trading costs of informed and uninformed traders.
Biais in 1993 analyses how the transparency of quotes affects spreads when there is no private information.
Madhaven also considers the issue of transparency by looking at the effects of knowing the volume of trade.
I believe that the simplest transparency issue to consider is how the degree to which the size and direction of order flow is visible to market participants affects the viability of the market.
The crucial function of any trading mechanism is Price Discovery or the process of finding market clearing prices.
This process will depend on the transparency of the market and therefore we need to consider which market structure better aids the price discovery function.
We can divide the market clearing mechanism into Quote Driven (QD) and Order Driven (OD)
Difference between a Quote Driven (QD) market and an Order Driven (OD) one?
The difference between these two market systems lies in what is displayed in the market in terms of orders and bid and ask prices. The order driven market displays all of the bids and asks, while the quote driven market focuses only on the bids and asks of market makers and other designated parties.
An order driven market is one in which all of the orders of both buyers and sellers are displayed, detailing the price at which they are willing to buy or sell a security and the amount of the security that they are willing to buy or sell at that price.
Let us now look at the properties of the resulting equilibrium in each market setting.
If the informational asymmetry in the market is not too great, then equilibrium will exist in the quote-driven system. In this state, security prices are semi-strong efficient and the market markers offers schedule of prices for different trade sizes rather than quote a single trading price.
If the information asymmetry is too large, it may not be possible to find such a price schedule and equilibrium may not exist.
In part two of this article we will discuss the benefits of transparency and how transparency affects the losses of the uninformed traders
FUTURES AND COMMODITIES TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. INFORMATION CONTAINED HEREIN IS STRICTLY THE OPINION OF ITS AUTHOR AND IS INTENDED FOR INFORMATIONAL PURPOSES. INFORMATION IS OBTAINED FROM SOURCES BELIEVED RELIABLE, BUT IS IN NO WAY GUARANTEED. OPINIONS, MARKET DATA AND RECOMMENDATIONS ARE SUBJECT TO CHANGE AT ANY TIME. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS
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