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The effect of automation on market microstructure

Jamal Munshi, Sonoma State University, 1991


All rights reserved

INTRODUCTION

Extant economic theories of markets and market microstructure may be


used to formulate a theory of of the price effects of exchange automation.
Studies by financial economists such as Barnea (1974), Beja (1979),
Amihud and Mendelson (1989) and others indicate that trading
mechanisms affect price behavior especially with regard to short term
components of price volatility. Further, theories of market automation
proposed by Garbade and Silber (1979), Amihud and Mendelson (1990),
Schwartz (1985), Miller (1989) and others all indicate that exchange
automation changes the microstructure of the market. Based on these
studies we deduce and test the theory that automation changes the
component of price volatility that is generated by the trading mechanism.

To test this theory we study the implementation of the Electronic Display


Book on the floor of the New York Stock Exchange and postulate that the
excess intraday price volatility that may be ascribed to trading mechanism
will change when the EDB is deployed. Fortuitously, the EDB was
deployed over a three year period using over 100 implementation dates to
convert about a thousand stocks to the new technology. This allows the use
of 'event time' methodologies to cancel out concomitant historical effects
from the quasi-experimental design. Further, economic effects are factored
out of intraday changes by using a regression technique which leaves
residuals, termed 'excess intraday volatility'. This quantity is ascribed to
trading mechanism effects and is therefore postulated as the appropriate
response variable for measuring the impact of the information system.

Using trading volume and market movement as control variables, it is


found with 'intervention analysis' that at trading volumes higher than
100,000 shares per day and in cases where the daily price movement is at
least three ticks, the excess intraday price volatility of stocks is lower after
EDB implementation (see Figure 1 below). At lower trading volumes or
when the price is not moving (by three ticks or more), no difference in
excess volatility is detected.
Volatility is an important property of markets. In particular, lower
volatility is a desirable property in market design. This is because in a
mean-variance world of risk averse utility maximizers governed by the
efficient market hypothesis (Markowitz 1959, Sharpe 1963, Fama 1970)
investors will demand additional returns to bear the excess volatility
generated by the market mechanism. As a result the overall investment into
productive assets in the macro economy would be less than it would have
been had the stock market been frictionless. However, the only real
function of markets is to provide liquidity and liquidity is related to
volatility. Market design that lowers volatility is desirable only to the
extent that this does not adversely affect liquidity. A test on liquidity is
therefore performed and it is found that there is no evidence that at least
one measure of liquidity is lower after the deployment of the electronic
limit order book. We may therefore conclude as follows: The
implementation of the electronic trading system has had a measurable
impact on price behavior. Volatility has been lowered without also
decreasing liquidity. The 'quality' of the EDB market is therefore
considered to be higher than that of the manual limit order book market.

For empirical research the problem of low statistical power may be


addressed by tightening the functional definitions whose success is to be
directly measured. For example, it may be difficult to measure the direct
effect of a new accounts receivable system on the wealth of the
shareholders but the measurement of the effect on mean collection time
and percentage of the Receivables actually collected within a given time
frame could be attempted. Such a measure can then be used to