Economics of Technology,

Securities, and Capital Markets

Katya Malinova

Electronic Trading Platforms & HFT

Source: Angel, Harris, Spatt "Equity Trading in the 21st Century"

  • Does not appear to be harmful (O'Hara & Ye (2011)). Except:

  • Except where there is:
    • Too much dark trading

      •  Degryse, de Jong, van Kervel (2014), Comerton-Forde & Putnins (2015)

    • Off-exchange internalization of retail orders
      • Comerton-Forde, Malinova, Park (2018)

Market Fragmentation

Electronic Trading Platforms & HFT: what do we know?

  • Numerous papers. Surveys: Jones (2013), Biais and Foucault (2014), Menkveld (2016), Foucault and Moinas (2018)

  • HFT is an umbrella term that covers many different strategies
  • Pros:

    • liquidity

    • (short-term) price efficiency

    • lower inventory costs

  • Cons:
    • adverse selection costs for slower traders
    • arms race (Budish, Cramton, Shim (2015))

High Frequency Trading

Electronic Trading Platforms & HFT: what do we know?

Industrial Organization of Exchanges

  • Optimal design of a system to match buyers and sellers?
    • Does competition lead to "first best"?
    • Or do we need regulatory intervention?
  • Existing work: suboptimal competitive outcomes
    • Budish, Lee, and Shim (2019), Pagnotta&Philippon (2016), Cespa&Vives (2019)

Electronic Trading Platforms & HFT: Open Questions

Long-term Impact 

  • Magnitude of effects?
  • Long term price discovery? (Weller (2018)
  • Impact on portfolio decisions and asset pricing?

A glimpse of a stock trade today

Alice wants to sell ABX

Bob wants to buy ABX

sell order

buy order

Clearing House

Stock Exchange

Broker

Broker

3rd party tech

custodian

custodian

record beneficial ownership

central bank for payment

Would we design market this way if we were to start "from scratch" today?

"silos" &

painful

transaction 

reconciliation

"joint ,single system"

Why worry about the distant future?

Nokia's market shares for devices:

  • 2007: 49.4%
  • 2012: 3%

Why worry about the distant future?

Paid-for vs. valued 

  • Keyboard
  • Security
  • Being businessy
  • Cool and cutting edge
  • Being Canadian
  • Independence from desk

What did they pay for?

What do people value?

  • Mobile email
  • Brand name
  • Easy access to branch
  • Great product range
  • Fair prices
  • Great advice
  • Latest tech
  • Friendly tellers
  • Safe-keeping of assets

As banks move data into "the cloud," why do we need banks?

Blackberry vs. a Generic Bank 

Generic Bank

Key Insight: Open Platforms provide value

What took the place of Blackberry?

App stores

  • 1 billion WeChat users
  • >150K in Greater Toronto 

Is the future distant? 

  • China:
    • "single entity" solutions to overcome payment frictions
  • By-product?
    • Ant Financial is the largest money market fund in the world ... (by accident?)

Risks of resolving frictions with tech-first?

Distributed Ledger/Blockchain Technology

  • A promise of a "joint, single system"
  • Features:
    • secure storage of information
    • guaranteed execution of code
  • Challenges (esp. to the public one):
    • getting info onto the ledger
    • don't trust the participants, need sufficient incentives to maintain security and integrity
      • consensus protocols

Blockchain Technology

  • How to change the "database"?

    • Who can do this? 

    • How do we agree on transition validity?

    • Ensure that past is difficult to change?

  • Example: Proof-of-Work protocol (Bitcoin)

    • cost = computing resources

    • arms race? 

  • Many other consensus mechanisms are "work in progress"

Consensus

  • Is there an economically sustainable consensus?

    • Blockchain maintenance is an equilibrium

    • Sustainable resource usage

    • (?) High capacity (Visa: 2K trans per sec; Bitcoin: 3-4)

    • Bias et al (2019), Saleh (2019), Rosu & Saleh (2019),...
  • Compensation for transaction verification?

    • Huberman, Leshno and Moallemi (2017) and Easley, O’Hara, and Basu (2019), Chiu and Koeppl (2017), Budish (2019) 

Consensus

Blockchain Technology: Issues and Questions

  • Ongoing research in computer science (and now in econ, fin, ...) 
    • Avalanche (Cornell), Algorand (MIT)
  • Why might it have value?
    • "convenience yield"
    • censorship aversion
    • value related to the cost of mining 
    • "membership" goods 
  • Biais, Bisiere, Bouvard, Casamatta, and Menkveld (2018), Pagnotta and Buraschi (2019), Sockin and Xiong (2018), Pagnotta (2019)

Cryptocurrency Valuation

  • Other Issues?
    • speculation  
      • Yermack (2015), Schilling&Uhlig (2019), Bolt&van Oordt (2019)
    • optimal monetary policy?
    • multiple coordination equilibria \(\to\) zero value or price jumps?

Blockchain Technology: Issues and Questions

  • Public blockchains offer censorship resistance ...
    • may not want that in financial services
  • Private/Permissioned (Hyperledger, JP Morgans' Quorum,...)
    • AML & KYC
    • Other ways to pay for transaction verification
    • But: difficult to keep a consortium together

Private vs Public

Blockchain Technology: Governance Issues

  • Decentralized vs. Centralized Record-Keeping?
  • Abadi and Brunnermeier (2018) & Chen, Cong, and Xiao (2019)
    • Each system has pros and cons
    • "can't have it all"
  • Since Jan 2016: $31 billion for 1,700+ early start-ups
  • TMX Venture (successful, since 1999, for junior firms)
    • $42 billion market cap (since 1999!)
    • In 2018: 52 IPOs, $2.2 billion
  • Private markets in Ontario: raised $70 billion in 2017 

Initial Coin Offerings (ICOs)

Coins and Tokens

  • Lessons?
    • Lots of interest in FinTech
    • Appetite by retail investors for risk/early stage firms
    • Possible to raise funds directly from investors
    • VCs and intermediaries do provide service
      • money does not substitute for business plan/advice
      • "wisdom of the crowd" is non-existent (?)

Initial Coin Offerings (ICOs)

Coins and Tokens

  • Many, many empirical stylized facts 

    • Determinants of success & ICO performance

    • Lyandres, Palazzo, Rabetti (2019): ICOs are surprisingly like IPOs

  • Surveys: Hilary ad Liu (2019),  Li and Mann (2019)

Initial Coin Offerings (ICOs)

Coins and Tokens

  • Economic role of tokens?
    • Mitigate coordination problems in platform adoption  
      • Bakos and Halaburda (2019), Li and Mann (2018), Cong, Li, and Wang (2019)
    • Presale through tokens helps resolve moral hazard (Malinova and Park (2019))
    • Signaling consumer interest/project viability (Lee,Li, Shin (2019))
    • Can extract consumer surplus & finance projects that are not profitable with competitive product market pricing (Lee&Parlour)

Initial Coin Offerings (ICOs)

Coins and Tokens

Economic impact of "tokenize everything"?

More efficient portfolios?

Big Data, Machine Learning, AI

Big Data, Machine Learning, AI

  • Data is valuable
  • Alternative data:
    • Better Governance Mechanism (Zhu (2019))
    • Too much of "low quality" info may discourage long-term info acquisition (Dugast and Foucault (2018))
  • Concerns?
    • Privacy? 
    • Discrimination?
    • Opacity of algos!

Big Data, Machine Learning, AI

  • Useful tools for prediction
    • Outperform standard forecasting models (Gu, Kelly, Xiu (2019))
  • ML/AI is an "umbrella term"
    • Many, many, many different tools!
  • Not a "magic wand"

Big Data, Machine Learning, AI

  • MIND: Horizons ACTIVE A.I. GLOBAL EQUITY ETF
  • "The ETF allocates its equity index exposure using a proprietary artificial intelligence selection process that extracts patterns from analyzing data"

MIND

MSCI World Index

"Part of its underperformance [relative to the MSCI Index] was because the artificial intelligence behind the ETF didn’t include currency hedging" (Horizons ETFs Canada CEO Steve Hawkins)

Big Data, Machine Learning, AI

Economic Issues and Concerns

  • Interpretability
    • How did the machine come to the conclusion?
    • What are policy implications?
  • Fairness and non-discrimination
    • biased training data
  • Manipulability
  • Stability and robustness
    • Common strategies
    • Larger reliance on the same data
    • Horizon's CEO: “You don’t really know what you can expect until you’re running something live"
  • New tools\(\to\) new assets
  • Exchange-Traded Funds
    • Cost-efficient tools 
  • A variety of impacts: E.g.,
    • hedge industry-specific risks (Huang, O’Hara, and Zhong (2018))
    • stocks in ETFs incorporate systematic info faster (Glosten, Nallareddy, and Zou (2019))
    • but: lower response to stock-specific news (Da and Shive (2017))

ETFs

New Assets, Robo-Advising, and Passive Investing

ETFs, Robo-Advising, and Passive Investing

  • Robo-Advice:
    • simple automated advice, often ETFs
    • reduces behavioral biases
    • improves diversification
      • D’Acunto, Prabhala, and Rossi (2019)
  • ETFs + Robo \(\to\) more passive 
    • Passive vs. active: "efficiently inefficient markets"
    • Garleanu and Pedersen (2018) (following Grossman&Stiglitz (1980), but  with asset managers)

A Tale of Railroads

US Standard railroad gauge (distance between the rails) is 4 feet, 8 1/2 inches

Because that's the way they built them in England

that's the gauge used for pre-railroad tramways

the same jigs and tools that they used for building wagons, which used that wheel spacing

other wheels would break on  old roads. Because that's the spacing of the old wheel ruts

The first long distance roads in Europe were built by Imperial Rome

Economic Insights for Regulation?

  • New risks 
  • Functions and entities that create market failures change or disappear:
    • fewer intermediaries \(\to\) fewer agency conflicts
      • but:  new entities hold deposits
    • smart contracts \(\to\)real-time view of transactions 
      • but: only as "smart" as their source code (code audit?)
  • Moving to open systems requires international cooperation ....

@katyamalinova

malinovk@mcmaster.ca

slides.com/kmalinova

https://sites.google.com/site/katyamalinova/

This survey: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3461760

Technological Innovation

Recent Technological Advances 

  • Electronic Trading Platforms and HFT
  • Blockchain
  • Cloud Computing

Infrastructure

Operation

Data Analytics

  • Machine Learning &Artificial Intelligence
  • New Asset Classes
  • Robo-Advisors

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