In Part I, we examined an overview of the design of the CASTrader II dark market and it's components. In this Part II, we will look at the type and structure of the market itself and various options for it. It's not necessary that the dark market need follow the typical Dutch double auction or Continuous Double Auction (CDA) format, as there are many other types studied in the field of auction theory.
Existing design. CASTrader I used a very simple dark market that could be extended to CASTrader II and modified to account for transaction costs. Very simply, the CASTrader I dark market polled each trader about how much of a security they would like to buy or sell at a given price, matched buys and sells until a net trade emerged. The net buy or sell trade would then be assumed to be executed at the current real market price. This method has several advantages:
- Simplicity - I doubt any market is easier to code.
- Minimal transaction costs - Although CASTrader I did not take into account transaction costs, it could be modified to include them. Commission and spread costs would only apply to the net trade and be spread over all traders, minimizing them. The bid-ask spread is said to be the penalty for a market order. Market orders would thus be cheaper.
- No internal liquidity issues - Traders effectively have all the liquidity they want via the net trade clearing mechanism (assuming real market liquidity exists).
The existing design has the following drawbacks, however:
- Requires a reference price - When traders are polled, there must be a reference price they are polled with. This price must be the price of the real market. Large, real bid-ask spreads will complicate this somewhat. Also, when the market is closed, there is no reference price, so the 24/7 dark market doesn't mean much.
- Transaction costs - however minimal, they still exist. Moreover, they are an unknown quantity to the trader at the time of polling because they depend on the net trade. Transaction costs, especially unknown ones complicate trading strategies and rule out others.
- Inefficiency - Unless the design is made more complex, this design is inefficient in that each trader is activated and polled every time the price changes. If the trader is running on a different computer than the market, this can really slow things down. Efficiency can be somewhat improved at the expense of the programming simplicity advantage.
In the final analysis, the best design of the dark market is the one that gives CASTrader the best advantage over the real market. For reasons I won't belabor, I think the commission-free market I outlined in Part I is the better choice in this respect, although I certainly can't prove it. It will come at a cost of more programming complexity, but once complete, I think it will prove extremely useful and extendable. The future plans of CASTrader call for markets of securities that have no real-world analog and hence no "reference" price, thus some alternative to the old design will have to be developed. The old design can always be revisited later as an alternative and/or submarket to the commission-free market.
Other Designs. Optimark was patented by IBM as an alternative and is discussed here. It appears to be designed to give large institutional traders a way to trade without moving the market. I suspect with the rise of algorithmic trading as a method to do the same thing within the existing market framework, they are having some challenges selling it. The Vickrey Auction has some applications in other domains, but appears to be a poor choice for a securities market or CASTrader. This paper indicates that double auctions are more communication efficient than some other auction types in a grid computing environment. By extension, I'd guess it's generally efficient in a non-grid environment as well.
Even very different forms of markets could be examined. The recent rise of prediction markets has resulted in testing out various new forms of markets. Some of these new types of markets don't need market makers at all as CDAs typically do in thin markets. These include Robin Hanson's Market Scoring Rules (update: David Pennock has an excellent article on Implementing Hanson's Market Maker) and David Pennock's Dynamic Pari-mutuel Market (DPM) of which Pennock writes:
To my knowledge, a DPM is the only known mechanism for hedging and speculating that exhibits all three of the following properties: (1) guaranteed liquidity, (2) no risk for the market institution, and (3) continuous incorporation of information. A standard pari-mutuel fails (3). A CDA fails (1). A CDAwMM, the bookmaker mechanism, and an MSR all fail (2). Even though technically an MSR exposes its patron to risk (i.e., a variable future payoff), the patron's maximum loss is bounded, so the distinction between a DPM and an MSR in terms of these three properties is more technical than practical.
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A DPM also has some drawbacks. The payoff for a wager depends both on the price at the time of the trade, and on the final payoff per share at the market's close. This contrasts with the CDA variants, where the payoff vector across possible future outcomes is fixed at the time of the trade.
Hanson's combinatorial market (via the Now Economy) offers some interesting possibilities as well, such as betting on mutually exclusive outcomes. I plan to add near frictionless prediction markets to CASTrader at some point, giving yet-to-be-designed traders new ways to trade. For example, a atrader may hedge a stock bet with bets on the pedicted outcome of GDP. These alternative market forms may be useful for that down the road design.
Choice for CASTrader. For now, however, it appears that the tried and true continuous double auction (CDA) is as good of choice for a market as I will find for CASTrader's immediate needs. The main drawback of the CDA is liquidity, which I will address via market makers as discussed in Part III. There are some efficient algorithms for CDAs that may be of some use.
Limit Order Book. Traders will be able to place limit orders on the CDA dark market, and unlike some stock exchanges like the NYSE, the order book will be fully open and fully electronic, so traders can see the liquidity available. There is no reason to use a specialist system or make the order book closed, and I believe this design may give CASTrader another potential edge over the real markets. That said, CASTrader will not feature any traders who intentionally exploit the order book information to trade until some later date.
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