Liquidity and efficiency during unusual market conditions : an analysis of short selling restrictions and expiration-day procedures on the London Stock Exchange
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While enhancing market quality has always been an important goal, this challenge has taken on even greater significance with increasing competition between securities markets both nationally and internationally. This thesis examines the influence of several key market design features on the market quality of the London Stock Exchange (LSE). The first issue examined is the impact of regulatory changes to short selling constraints on liquidity and order flow during periods of extreme uncertainty. During the 2008-9 UK emergency temporary short selling ban, restricted stocks experienced lower trading activity, wider spreads, reduced order book depth, and more aggressive trading. The restrictions occurred at a time of extreme uncertainty when price volatility increased and there was more trading activity in the upstairs market. Our findings suggest that limit order trading may be less viable during turbulent times and should interest policymakers concerned with maintaining fair markets during crisis periods. Second, this thesis examines trading conditions during another period of market strain; index derivatives expiration days. Previously unexamined, the LSE employs a unique intraday call auction procedure to minimise expiration-day effects on underlying stocks. Price and volume data is examined around the expiration of FTSE 100 index futures and option contracts to determine the efficacy of the UK approach. Evidence of significant increases in trading volume and abnormal stock returns in the underlying market on expiration days is found. However, the effects are short-lived and small relative to transactions costs, suggesting that use of an intraday call auction mechanism is effective in maintaining a fair and orderly market. The third issue analysed in this thesis is whether current expiration-day procedures give rise to exploitable market efficiencies. Individual stock returns prior to expiration are found to help predict future prices in the short-term. This predictive ability is used to derive trading strategies which are tested under real-world conditions to search for systematic profitable trading opportunities. Although the model forecasts produce higher returns than a passive benchmark, the gains are small after allowing for transaction costs implying that LSE expiration-day procedures foster an efficient market. This thesis has implications for economic efficiency and policy. Together, study of these distinctive market design features of the LSE and their respective impacts on liquidity and market efficiency contributes to an enhanced understanding of optimal market design. Our findings should interest academics and market operators concerned with maintaining fair and efficient markets, particularly during critical trading periods.
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