Thomas Ernst
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Publications
Would Order-By-Order Auctions Be Competitive? - with Chester Spatt and Jian Sun.
Forthcoming at the Journal of Finance
We model two methods of executing segregated retail orders: broker's routing, whereby brokers allocate orders using market maker's overall performance, and order-by-order auctions, where market makers bid on individual orders, a recent SEC proposal. Order-by-order auctions improve allocative efficiency, but face a winner's curse reducing retail investor welfare, particularly when liquidity is limited. Additional market participants competing for retail orders fail to improve total efficiency and investor welfare when entrants possess information superior to incumbent wholesalers. Our results remain robust when new entrants are less informed or the information structure differs. We also examine the cross-subsidization of broker's routing.
Payment for Order Flow And Option Internalization - with Chester Spatt.
Forthcoming at the Review of Financial Studies
Option wholesalers specialize in purchasing and executing against retail option order flow. Orders are internalized via auctions (which provide price improvement) and the limit order book. Designated Market Makers (DMMs) have a key advantage in internalizing limit order book trades: they obtain the first 5 contracts of any order they bring to an exchange where they are a DMM. We exploit variation in DMM assignments and allocation rules to highlight how these rules create a barrier to entry in option wholesaling that does not exist for equity wholesaling, protecting wholesaler profits and high option PFOF.
Working Papers
Stock Specific Price Discovery From ETFs
Online Appendix
Conventional wisdom warns that exchange-traded funds (ETFs) harm stock price discovery, either by "stealing'' single-stock liquidity or forcing stock prices to co-move. Contra this belief, I develop a theoretical model and present empirical evidence which demonstrate that investors with stock-specific information trade both single stocks and ETFs. Single-stock investors can access ETF liquidity by means of this tandem trading, and stock prices can flexibly adjust to ETF price movements. Using high-resolution data on over 500 ETFs, I exploit exchange latencies in order to show that investors place simultaneous, same-direction trades in both a stock and ETF. Consistent with my model predictions, effects are strongest when an individual stock has a large weight in the ETF and a large stock-specific informational asymmetry. I conclude that ETFs do provide single-stock price discovery.
The Value of Off-Exchange Data - with Chester Spatt and Jonathan Sokobin.
Revise and Resubmit at the Review of Financial Studies
Exploiting the structure of geographic latencies, we study the effect of trade reporting of off-exchange equity transactions and contrast that with reporting of exchange trading. Publication of off-exchange transactions by the Securities Information Processor (SIP), leads to a sharp burst in trading and quoting activity, suggesting that market participants learn from those reports, with their unique information content lingering throughout the lengthy reporting process. In contrast, there is no spike in response to SIP publication of exchange trading, but instead an earlier spike that reflects the response to the near-immediate reporting from proprietary feeds. Due to the varied locations of the off-exchange trade reporting facilities (TRFs), SIPs and exchanges, we use distinct geographical latencies to pinpoint the patterns. We document that realized spreads for the TRF-response trades are negative, consistent with these orders being informationally-motivated and contributing to price discovery.
What Does Best Execution Look Like? - with Andrey Malenko, Chester Spatt, and Jian Sun.
Revise and Resubmit at the Journal of Finance
U.S. retail brokers must provide "best execution" for client orders, though how this works in practice remains unclear. We model the interaction between brokers and wholesalers executing orders as imperfect competition where privately-informed wholesalers compete for future order flow through current price improvement, with brokers designing allocation rules to enhance competition. Using data from three large retail brokers, we document three findings. First, brokers allocate more orders to wholesalers with better past performance. Second, wholesalers recognize this and respond strategically to broker routing criteria and competitive pressures. Finally, there are differences among stocks and brokers in how competition is managed.
Why Did Retail Liquidity Programs Fail? - with Chester Spatt and Jian Sun.
Exploiting the structure of geographic latencies, we study the effect of trade reporting of off-exchange equity transactions and contrast that with reporting of exchange trading. Publication of off-exchange transactions by the Securities Information Processor (SIP), leads to a sharp burst in trading and quoting activity, suggesting that market participants learn from those reports, with their unique information content lingering throughout the lengthy reporting process. In contrast, there is no spike in response to SIP publication of exchange trading, but instead an earlier spike that reflects the response to the near-immediate reporting from proprietary feeds. Due to the varied locations of the off-exchange trade reporting facilities (TRFs), SIPs and exchanges, we use distinct geographical latencies to pinpoint the patterns. We document that realized spreads for the TRF-response trades are negative, consistent with these orders being informationally-motivated and contributing to price discovery.
Policy
Payment for Order Flow and the Retail Trading Experience -a WIFPR whitepaper with Chester Spatt.
U.S. retail brokers have shifted to a business model with zerocommission trades, earning much of their revenue through payment for order flow (PFOF), under which wholesalers pay brokers to route the orders of their retail clients. The presence of PFOF has led to potential concerns about whether it leads to distortions in routing decisions by brokers, a reduction in market quality due to its effect in segmenting retail orders, or changes in the brokers’ incentives to encourage excess trading. While the recent SEC regulatory focus has been on equity markets, two-thirds of all PFOF comes from option markets. PFOF rates in option markets are much larger, creating a system where broker revenue is much higher when retail clients trade options compared to equities, leading to potential incentives to encourage option trading. We consider the current SEC proposal for order-by-order auctions in retail equity trading and its implications for retail investor welfare. We address three alternatives. First, we propose an expansion of equity Retail Liquidity Programs rather than mandated retail auctions. Second, we consider changes to option markets to reduce frictions, which could include fee caps, competitive designatedmarket-maker assignments, and a more competitive auction process. Finally, we suggest a PFOF-fee cap, which would preserve PFOF, while addressing the large cross-asset PFOF fee differences.
Regulating Market Microstructure - with Chester Spatt.
Forthcoming at the Annual Review of Financial Economics