Electronic Thesis and Dissertation Repository

Degree

Doctor of Philosophy

Program

Applied Mathematics

Supervisor

Adam Metzler

Abstract

Market structure concerns the mechanisms for negotiating trades and the composition of trading participants, and can affect liquidity and price efficiency. More gains from trade can be realized from an asset that is more liquid, and a better allocation of risk and capital can be achieved when an asset’s price is more efficient so it is important to understand market structure. This thesis uses theory and empirical methods to examine the effects of a few specific aspects of market structure.

In Chapter 1, we study a novel market structure on the New York Stock Exchange (NYSE), the Retail Liqudity Program (RLP), that allows liquidity providers to trade specifically with retail traders. We test whether it affected the quality of trading opportunities for retail and non-retail traders by measuring transaction costs before and after the RLP was launched. We find transaction costs are slightly lower for both retail and non-retail traders. We also find evi- dence of an improved price-discovery process from allowing market participants to distinguish between retail trades, which contribute little to price discovery, and non-retail trades, which contribute more so.

In Chapter 2, we extend a classic model of market microstructure to formalize the hypothe- ses and findings from Chapter 1 and to form new predictions. Under the models assumptions, prices are more efficient, and the effect on liquidity is ambiguous. We develop predictions of how informed traders adjust their trading strategies in the presence of the RLP.

In Chapter 3, we consider a market where a significant amount of trading is motivated by hedging. We use a classic microstructure model to examine how a market makers willingness to provide liquidity is affected by the need to learn about the underlying value of an asset as well as the inventory of a hedging trader. Under our models assumptions, a market maker provides more liquidity in the presence of hedging. We test our prediction empirically by studying the effect of predictable increases in trading volume that occur near the expiry of stock options. We find the evidence that hedging trades result in improved liquidity.