Conference Agenda

We study the optimal execution problem in a principal-agent setting. A client (e.g., a pension fund, endowment, or other institution) contracts to purchase a large position from a dealer at a future point in time. In the interim, the dealer acquires the position from the market, choosing how to divide his trading across time. Price impact may have temporary and permanent components. There is hidden action in that the client cannot directly dictate the dealer’s trades. Rather, she chooses a contract with the goal of minimizing her expected payment, given the price process and an understanding of the dealer’s incentives. Many contracts used in practice prescribe a payment equal to some weighted average of the market prices within the execution window. We explicitly characterize the optimal such weights: they are symmetric and generally U-shaped over time. This U-shape is strengthened by permanent price impact and weakened by both temporary price impact and dealer risk aversion. In contrast, the first-best solution (which reduces to a classical optimal execution problem) is invariant to these parameters. Back-of-the- envelope calculations suggest that switching to our optimal contract could save clients billions of dollars per year.

We show that the trading-fee breakdown (fee pricing) depends on the distribution of investor gains-from-trade relative to the tick size. Absent price discreteness, an increase in investor gains-from-trade increases the total fee proportionally, but the fee breakdown has no effect. With price discreteness, the fee breakdown can mitigate the loss of welfare due to difficulty in trading when gains-from-trade are small relative to the tick size. However, when gains-from-trade are large, the exchange fee breakdown plays only a small role and exchanges extract rents from investors gains-from-trade by increasing total fee. The resulting gap between welfare relative to fees set by a Social Planner can be large. Consequently, a regulator can improve welfare substantially by imposing a cap on exchange fees.

I study a futures market model with imperfectly competitive traders, some precluded to trade spot (financial traders), some not (physical traders). I first show that, suprisingly, introducing futures makes physical traders worse off without financial traders, because physical traders seek to influence futures payoff by trading spot, and choose negative hedging ratios. Financial traders improve futures market liquidity, so that physical traders adopt positive hedging ratios when liquidity is sufficiently improved. However financial traders also raise prices when they are long, which benefits high-inventory physical traders at the expense of low-inventory physical traders. Overall, physical traders with high or very low inventory are better off with financial traders than without futures, while traders with intermediate inventory and trading in the same direction as financial traders lose. I also show that imperfect competition makes futures and spot market imperfect substitutes, implying a spot-futures basis.