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Market
Microstructure
in Practice

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Market
Microstructure
in Practice

Editors

Charles-Albert Lehalle
Capital Fund Management, France

Sophie Laruelle
Université Paris-Est Créteil, France

World Scientific
NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TA I P E I • CHENNAI

8967_9789814566162_tp.indd 2 8/10/13 1:30 PM

Published by
World Scientific Publishing Co. Pte. Ltd.
5 Toh Tuck Link, Singapore 596224
USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601
UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE

Library of Congress Cataloging-in-Publication Data

Lehalle, Charles-Albert.
Market microstructure in practice / Charles-Albert Lehalle (Capital Fund Management, France)
& Sophie Laruelle (Universite Paris-Est Creteil, France).
pages cm
Includes bibliographical references and index.
ISBN 978-9814566162 (hardcover : alk. paper)
1. Capital market. 2. Finance. 3. Stock exchanges. I. Laruelle, Sophie. II. Title.
HG4523.L44 2013
332'.0415--dc23
2013031361

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Copyright © 2014 by World Scientific Publishing Co. Pte. Ltd.

All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,
electronic or mechanical, including photocopying, recording or any information storage and retrieval
system now known or to be invented, without written permission from the Publisher.

For photocopying of material in this volume, please pay a copying fee through the Copyright
Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to
photocopy is not required from the publisher.

In-house Editor: Chye Shu Wen

Typeset by Stallion Press

Email: enquiries@[Link]

Printed in Singapore
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

About the Editors

Currently Senior Research Manager at

Capital Fund Management (CFM),
Charles-Albert Lehalle is an interna-
tional expert in market microstructure
and optimal trading. Formerly Global
Head of Quantitative Research at Crédit
Agricole Cheuvreux, and Head of Quanti-
tative Research on Market Microstructure
in the Equity Brokerage and Derivative
Department of Crédit Agricole Corpo-
rate Investment Bank, he has been study-
ing the market microstructure since regulatory changes in Europe
and in the US took place. He provided research and expertise on
this topic to investors and intermediaries, and is often heard by
regulators and policy-makers like the European Commission, the
French Senate, the UK Foresight Committee, etc.

Currently Assistant Professor at Uni-

versité Paris-Est Créteil (UPEC), Sophie
Laruelle defended her PhD in decem-
ber 2011 under the supervision of Gilles
Pagès on analysis of stochastic algo-
rithms applied to Finance. During her
PhD, she made two contributions on
market microstructure in collaboration
with Charles-Albert Lehalle: The first one
on the optimal allocation among dark

v
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vi Market Microstructure in Practice

pools and the second on optimal posting price in the limit order book.
Then she worked at Ecole Centrale Paris with Frédéric Abergel on
agent-based models and now she continues to work on applications
of stochastic approximation theory, notably in market microstructure
for building trading algorithms.
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

About the Contributors

Romain Burgot graduated from ENSAE in 2006, and he started to

get curious about market microstructure during his time at ENSAE.
He worked directly in this field as a quant analyst and consequently
observed the establishment of whole equity trading fragmentation in
Europe. He took part in the first stages of building a team of efficient
researchers in the domain. He helped in market data processing,
visualization, modeling and robust statistical estimations for bench-
marked agency brokerage execution algorithms. His main interests
lie in volume volatility spread joint dynamics, the influence of tick
size on trading and helping regulators get understanding in equity
trading evolutions.

Stéphanie Pelin works as a Quant Analyst in the Quantitative

Research team of Kepler Cheuvreux. For the past four years, she has
conducted quantitative analysis on Corporate Brokerage strategies,
focusing on stocks’ liquidity characterization or price guaranteed
interventions. She regularly published documents where pertinent
issues in financial markets’ microstructure were investigated, in
particular with regards to fragmentation and European equity
markets regulation, e.g. MiFID. Stéphanie graduated with a [Link].
from Paris Dauphine University; majoring in Applied Mathematics
and Financial Markets. She started her professional experience by
studying energy products in an Asset Management firm.

Matthieu Lasnier was admitted at the Ecole Normale Superieure

in Lyon and he graduated as an engineer from ENSAE. He holds
the Master of Science in Financial Mathematics at the University
Denis Diderot-Paris 7. Currently a quantitative analyst at Kepler-
Cheuvreux, Matthieu Lasnier’s fields of expertise include the study

vii
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viii Market Microstructure in Practice

of the price formation process with a focus on market impact

questions. He has been working with the quantitative research team
of CA Cheuvreux in New York and in Paris since 2009. His core
field is financial mathematics, in particular statistical analysis of
high-frequency financial data. The questions he faces overlap with
the design of statistical arbitrage strategies, the optimization of
execution trading algorithm, as well as the study of the market
impact. In the context of raising fragmentation of the European
equity markets, he is a contributor to Navigating Liquidity.
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

Contents

About the Editors v

About the Contributors vii
Foreword by xv
Robert Almgren . . . . . . . . . . . . . . . . . . . . . . . . xv
Bertrand Patillet . . . . . . . . . . . . . . . . . . . . . . . . xvi
Philippe Guillot . . . . . . . . . . . . . . . . . . . . . . . . xvii
Albert J. Menkveld . . . . . . . . . . . . . . . . . . . . . . xix

Preface by xxi
Charles-Albert Lehalle . . . . . . . . . . . . . . . . . . . . xxi
Sophie Laruelle . . . . . . . . . . . . . . . . . . . . . . . . xxiv

Introduction 1

1. Monitoring the Fragmentation at Any Scale 29

1.1 Fluctuations of Market Shares: A First Graph
on Liquidity . . . . . . . . . . . . . . . . . . . . . . . 29
1.1.1 The market share: A not so obvious liquidity
metric . . . . . . . . . . . . . . . . . . . . . . . 29
1.1.2 Phase 1: First attempts of fragmentation . . . 34
1.1.3 Phase 2: Convergence towards a European
offer . . . . . . . . . . . . . . . . . . . . . . . . 44
1.1.4 Phase 3: Apparition of broker crossing
networks and Dark Pools . . . . . . . . . . . 49
1.2 Smart Order Routing (SOR), A Structural Component
of European Price Formation Process . . . . . . . . . 56

ix
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x Market Microstructure in Practice

1.2.1
How to route orders in a fragmented market? 56
1.2.2
Fragmentation is a consequence of primary
markets’ variance . . . . . . . . . . . . . . . . 64
1.3 Still Looking for the Optimal Tick Size . . . . . . . . 67
1.3.1 Why does tick size matter? . . . . . . . . . . . 67
1.3.2 How tick size affects market quality . . . . . 70
1.3.3 How can tick size be used by trading venue to
earn market share? . . . . . . . . . . . . . . . 84
1.3.4 How does tick size change the profitability of
the various participants in the market? . . . . 90
1.3.5 The value of a quote . . . . . . . . . . . . . . 92
1.4 Can We See in the Dark? . . . . . . . . . . . . . . . . 94
1.4.1 Mechanism of dark liquidity pools . . . . . . 95
1.4.2 In-depth analysis of dark liquidity . . . . . . 97

2. Understanding the Stakes and the Roots of Fragmentation 109

2.1 From Intraday Market Share to Volume Curves:
Some Stationarity Issues . . . . . . . . . . . . . . . . 109
2.1.1 Inventory-driven investors need fixing
auctions . . . . . . . . . . . . . . . . . . . . . 111
2.1.2 Timing is money: Investors need to trade
accordingly . . . . . . . . . . . . . . . . . . . 121
2.1.3 Fragmentation and the evolution of intraday
volume patterns . . . . . . . . . . . . . . . . . 131
2.2 Does More Liquidity Guarantee a Better Market
Share? A Little Story About the European Bid-Ask
Spread . . . . . . . . . . . . . . . . . . . . . . . . . . 134
2.2.1 The bid-ask spread and volatility move
accordingly . . . . . . . . . . . . . . . . . . . 136
2.2.2 Bid-ask spread and market share are deeply
linked . . . . . . . . . . . . . . . . . . . . . . . 139
2.2.3 Exchanges need to show volatility-resistance 142
2.3 The Agenda of High Frequency Traders: How Do
They Extend their Universe? . . . . . . . . . . . . . . 144
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Contents xi

2.3.1
Metrics for the balance in liquidity among
indexes . . . . . . . . . . . . . . . . . . . . . . 145
2.3.2 A history of coverage . . . . . . . . . . . . . . 147
2.3.3 High-frequency traders do not impact all
investors equally . . . . . . . . . . . . . . . . 149
2.4 The Link Between Fragmentation and Systemic Risk 155
2.4.1 The Spanish experiment . . . . . . . . . . . . 155
2.4.2 Volatility, cross-stock correlation, intraday,
extraday . . . . . . . . . . . . . . . . . . . . . 160
2.4.3 The Flash Crash (May 6th, 2010) in NY: How
far are we from systemic risk? . . . . . . . . . 173

3. Optimal Organisations for Optimal Trading 185

3.1 Organising a Trading Structure to Answer
to a Fragmented Landscape . . . . . . . . . . . . . . 185
3.1.1 Main inputs of trading tools . . . . . . . . . . 186
3.1.2 Components of trading algorithms . . . . . . 189
3.1.3 Main outputs of an automated trading system 190
3.2 Market Impact Measurements: Understanding the
Price Formation Process from the Viewpoint of One
Investor . . . . . . . . . . . . . . . . . . . . . . . . . . 195
3.2.1 Better understanding on what impacts
the price . . . . . . . . . . . . . . . . . . . . . 196
3.2.2 Market impact over the trading period . . . . 197
3.2.3 Market impact on a longer horizon: Different
patterns for different investment styles . . . . 200
3.2.4 Dependence between investment style and
market impact on a monthly horizon . . . . . 203
3.3 Optimal Trading Methods . . . . . . . . . . . . . . . 205
3.3.1 Algorithmic trading: Adapting trading style
to investors’ needs . . . . . . . . . . . . . . . 205
3.3.2 Liquidity seeking algorithms are no longer
nice to have . . . . . . . . . . . . . . . . . . . 210

Appendix A: Quantitative Appendix 221

A.1 From Entropy to FEI (Fragmentation Efficiency
Index) . . . . . . . . . . . . . . . . . . . . . . . . . 221
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xii Market Microstructure in Practice

A.2 Information Seeking and Price Discovery . . . . . 225

A.3 A Simple Model Explaining the Natural
Fragmentation of Market Microstructure . . . . . 229
A.3.1 A toy model of SOR dynamics . . . 229
A.3.2 A toy model of the impact of SOR
activity on the market shares . . . . 231
A.3.3 A coupled model of SOR-market
shares dynamics . . . . . . . . . . . 232
A.3.4 Simulations . . . . . . . . . . . . . . 232
A.3.5 Qualitative analysis . . . . . . . . . 233
A.4 A Toy Model of the Flash Crash . . . . . . . . . . . 235
A.4.1 A market depth-oriented model . . 235
A.4.2 Impact of the Flash Crash on our
model . . . . . . . . . . . . . . . . . 237
A.5 Harris Model: Underlying Continuous Spread
Discretized by Tick . . . . . . . . . . . . . . . . . . 240
Motivation and notations . . . . . . . . . 240
Numerical application . . . . . . . . . . . 243
A.6 Optimal Trade Scheduling . . . . . . . . . . . . . . 247
A.6.1 The trading model . . . . . . . . . . 248
A.6.2 Towards a mean-variance optimal
trade scheduling . . . . . . . . . . . 249
A.7 Estimation of Proportion and its Confidence
Intervals . . . . . . . . . . . . . . . . . . . . . . . . 255
A.7.1 Application to the estimation of the
market share of venues on an asset 256
A.7.2 Aggregation or application to the
market share on an index . . . . . . 256
A.7.3 Comparison of the estimators . . . 257
A.8 Gini Coefficient and Kolmogorov-Smirnov Test . . 259
A.8.1 Gini coefficient . . . . . . . . . . . . 259
A.8.2 Kolmogorov-Smirnov test . . . . . 260
A.8.3 Practical implementation . . . . . . 261
A.9 Simple Linear Regression Model . . . . . . . . . . 264
A.9.1 Model presentation . . . . . . . . . 265
A.9.2 Application to relation between
spread and volatility . . . . . . . . 266
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Contents xiii

A.10 Time Series and Seasonalities . . . . . . . . . . . . 270

A.10.1 Introduction to time series . . . . . 270
A.10.2 Example of volume model . . . . . 274
A.11 Clusters of Liquidity . . . . . . . . . . . . . . . . . 276
A.11.1 Introduction to point processes . . 276
A.11.2 One-dimensional Hawkes processes 279
A.12 Signature Plot and Epps Effect . . . . . . . . . . . 283
A.12.1 Volatility and signature plot . . . . 283
A.12.2 Correlation and Epps effect . . . . 284
A.13 Averaging Effect . . . . . . . . . . . . . . . . . . . . 286
A.13.1 Mean versus path . . . . . . . . . . 286
A.13.2 Regression of average quantities
versus mean of the regressions . . 286
Appendix B: Glossary 289
Bibliography 297
Index 303
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Foreword

Robert Almgren, President and Cofounder

of Quantitative Brokers
Fragmentation, the search for liquidity, and high-frequency traders:
These are the realities of modern markets. Traditional models of
market microstructure have studied the highly simplified interaction
between an idealized market maker or specialist, and a stream
of external orders that may come from noise traders or informed
traders. In the modern marketplace, the market itself is replaced
by a loosely coupled network of visible and hidden venues, linked
together by high frequency traders and by algorithmic strategies.
The distinction between market makers who post liquidity and
directional traders who take liquidity no longer exists. All traders are
searching for liquidity, which may be flickering across many different
locations with varying latencies, fill probabilities, and costs. That is
the world which this book addresses, treating these issues as central
and fundamental rather than unwelcome complexities on top of a
simple framework.
This market evolution is furthest along in equity markets, thanks
in large part to their size, social prominence as indicators of corporate
value, and large variety of active traders from retail investors to
sophisticated proprietary operations and large fundamental asset
managers. Regulation has also been most active in equity markets,
most importantly Reg NMS in the US and MiFiD in Europe. Other
asset markets, such as foreign exchange, futures, and fixed income,
are further back along this pathway, but it is clear that the direction
of evolution is toward the landscape treated in this book, rather than
back to simpler times. Regulation will continue to shape the further
development of all these markets, and all market participants have

xv
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xvi Market Microstructure in Practice

an interest in increasing the broad understanding of the underlying

issues by regulators as well as each other.
The central focus of the book is liquidity: Loosely speaking, the
ease and efficiency with which large transactions can be performed.
For any real user of the market this is the primary concern, although
academic researchers may focus on other aspects. Thus fragmen-
tation and high frequency trading are addressed from this point
of view. Throughout the book, the emphasis is on features of the
marketplace that are of tangible and pressing concern to traders,
investors, and regulators.
The authors have extensive personal experience of the develop-
ment of the European equity markets, as traders and as participants
in conversations with regulators and other interested parties. They
bring this experience to bear on every aspect of the discussion, as well
as deep quantitative understanding. The resulting book is a unique
mixture of real market knowledge and theoretical explanation. There
is nothing else out there like it, and this book will be a central resource
for many different market participants.

Bertrand Patillet, Deputy Chief Executive Officer

of CA Cheuvreux until April 2013
MiFID I removed the freedom of national regulators to maintain
the secular obligation to concentrate orders on historical markets. In
this way, the regulation, without a doubt, lifted the last regulatory
obstacle preventing Europe from experiencing — for better or for
worse perhaps — the macro- and micro-structural changes already
at work on North American markets. This complete shift in paradigm
was to render obsolete our savoir-faire and knowledge of how equity
markets work.
We needed to observe, analyse, understand, and, to a certain
extent, anticipate and foresee the consequences of the transforma-
tions underway that would drastically change the structure of inter
and intra-market liquidity and thus the nature of the information
conveyed by order books, the right reading of which is vital to obtain-
ing the best price for our clients. Only then, could we redefine our
approach to best execution, and adapt our behaviour and our tools.
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

Foreword xvii

We could not have achieved this task without resources hitherto

the monopoly of certain hedge funds or derivatives desks, but
unknown to agency brokers, namely profiles capable of extracting
useful information from market data in order to better model
new behaviours, validate or invalidate intuitions and ultimately
provide our traders with buy or sell decision-making tools in these
exceedingly complex markets. This is why, as early as 2006, we
decided to form a team of quantitative analysts with strong links
to the academic world, and headed by Charles-Albert, newly hired
at Crédit Agricole Cheuvreux. This move was to transform our
execution practices beyond our expectations and place us among
the leaders.
Before MiFID II imposes new rules for structuring financial mar-
kets, this book provides a point of view, far from the preconceived
ideas and pro domo pleas of such and such a lobby, on market micro-
structure issues — the subject of impassioned, fascinating, and as yet
unclosed debate — which will interest all those, who, in one respect
or another, are concerned with improving how equity markets work.

Philippe Guillot, Executive Director, Markets Directorate,

Autorité des marchés financiers (AMF)
When Charles-Albert asked me to write a foreword for his book on
markets microstructure, in which many of the topics are reminiscent
of the uncounted hours spent discussing them while we were at
Cheuvreux, he specifically asked for one (alas, only one) of the many
analogies I use to help people getting a grasp on microstructure. A
good proportion comes from comparing the electronics markets to
aviation, with a big difference worth noting: At the beginning of
aviation, as Igor Sikorsky said, the chief engineer was almost always
the chief test pilot, which had the fortunate result to eliminate poor
engineering at an early stage in aviation (could we do something
similar for algos?). When comparing the two today, what is probably
missed the most in the markets microstructure is common sense.
How can this be illustrated through MiFID? At first glance, one
clear beneficiary of MiFID is Mr Smith. When he bravely buys 500
shares of Crédit Agricole, the reduction in tick sizes that occurred
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xviii Market Microstructure in Practice

in the previous years means that rather than having to pay 6.95
per share when he crosses the spread, he now buys them at 6.949
(he still crosses the spread but, because his dealing size remained
smaller than the Average Trade Size, he still buys from the best offer)
and saves a whopping 0.5 every times he deals. Unfortunately,
whenever he does so, he is never sure that the price he has dealt at
is the one he has seen on his screen nor that the marketplace where
he has dealt is the one on which he was looking at the price. Add to
that some literature on HFT, predatory strategies and flash crashes:
No wonder the markets have lost Mr Smith’s confidence. Where is
the analogy with aviation?
When today’s engineers build an Airbus A380, they could really
simplify the problems by building it without windows when only
one out of six passengers sits next to one of them. The body of the
plane would not have to be reinforced around the panels and a lot
of weight would be saved. Add to that the reduction of drag when
flying and you could expect that some of these savings would be
passed to the passengers, maybe 0.5 every time he buys a plane
ticket.
Sadly, Mr Smith and many of his fellow travellers are not yet
ready to fly in a windowless plane for a 0.5 saving (you may have
also noticed that on automatic tube lines there is always a huge
windowpane at the front of the train in the unlikely event that there
is a risk of a head on crash with another train). Even if it is technically
possible today to fly a plane without a pilot, even if every serious
accident that occurred in this century has a human error to its origin,
the plane industry has realised how important it is to keep the trust
of customers.
Today, the markets have lost the trust of their most precious
customer, the most humble link in the markets ecosystem: The
uninformed trader. The ecosystem is damaged and repairing it will
be our biggest challenge of the coming years. Although politicians
may decide to make big bold changes, technicians and regulators
have to carefully use their considerable weight on the delicate levers
of markets microstructure.
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

Foreword xix

Charles’ and Sophie’s book on markets microstructure will

improve our knowledge and consequently help us to tweak these
potentiometers. In promoting better education, this book is at the
roots of restoring trust in the markets.

Albert J. Menkveld, Professor of Finance at VU University

Amsterdam and Research Fellow at TI-Duisenberg School
of Finance
We go to markets to buy and sell. Perhaps the oldest market still
around is the farmer’s market. Even New York City has them with
farmers driving their vans out to Manhattan to sell their wares at the
local square amid high-rises. It is a pleasant experience to go out on
a sunny day and buy your veggies fresh from the farmer.
That seems a far way off from modern securities markets.
Exchanges have moved from floor trading to servers that match
incoming buy and sell orders. These orders, in turn, were submitted
through electronic channels after traders typed them into their
terminals. Better yet, it seems that even the ’typing’ is increasingly
left to robots to gain speed. So, in today’s markets, decisions are
taken and trades go off at sub-millisecond speed. The clock speed of
a human brain is about 100 milliseconds.
The market place itself changes at a speed that is hard to
keep up with. Practitioners, academics, and regulators all wonder
whether these new electronic markets are better. But what is the
appropriate measure? To an economist, securities markets should
get the assets in the hands of those who have highest value for
them (given budget constraints). The assets should be allocated
optimally. Furthermore, an important by-product of trading is ‘price
discovery’. Prices reveal information about the fundamental value of
a security. They help shareholders discover poor management and
take appropriate action.
This book provides a perspective on today’s markets. It reviews
institutional changes, discusses them, and provides color through
real-world examples. It focuses mostly on European securities
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

xx Market Microstructure in Practice

markets. This does not make it less relevant in a global context as the
issues are very similar outside of Europe.
This perspective is an important contribution to the public
debate on modern markets. In the end, we might have gained from
automated markets as costly human intermediaries are replaced by
computers. And when a robot monitors the market for us, we will
have more time to go out and enjoy the farmer’s market.
October 10, 2013 15:37 9in x 6in Market Microstructure in Practice b1647-fm

Preface

Charles-Albert Lehalle, Senior Research Manager at Capital

Fund Management and former Global Head of Quantitative
Research at Crédit Agricole Cheuvreux
This book results from the conjunction of recent academic research
and day to day monitoring of the equity market microstructure
evolutions. Academic research targeted simultaneously the emer-
gence of a scientific framework to study the impact of market design
and agent behaviours on the price formation process (see [Lehalle
et al., 2010b] [Lehalle, 2012]), and to model and control the execution
costs and risks in such an ecosystem (see [Lehalle, 2008] [Lehalle,
2009] [Guéant et al., 2012b] [Guéant et al., 2012a] [Bouchard et al.,
2011]). This book aims to keep its content not too technical. Readers
interested in a deeper quantitative approach will find more details
and pointers in the Appendix.
Market microstructure monitoring has been motivated by
brokerage-oriented business needs. One of the roles of an inter-
mediary is to provide unbiased advices on available investment
instruments; an execution broker should provide independent anal-
yses on the price formation process. It sheds light on the market
valuation of financial instruments. This is one of the reasons why this
books owes a lot to Crédit Agricole Cheuvreux’ Navigating Liquidity
series ([Lehalle and Burgot, 2008] [Lehalle and Burgot, 2009b]
[Lehalle and Burgot, 2009a] [Lehalle and Burgot, 2010] [Lehalle et al.,
2010a] [Lehalle et al., 2012]). Moreover, internal discussions at CA
Cheuvreux (mainly with Bertrand Patillet and Philippe Guillot) as
well as intense debates with regulators and policy makers (like
Laurent Grillet-Aubert and Kay Swinburne) on the consequences

xxi
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