Paper 2022/451

Improved Stock Market Structure Using Cryptography

Abstract

The stock market has two primary functions, that of providing liquidity and price discovery. While historically, the market micro-structure was mostly ignored or assumed to function ideally for the purpose of asset pricing, O’Hara (Journal of Finance, 2003) established that both liquidity and price discovery affect asset pricing, and consequently asset returns. In this work, we extend the analysis of Easley and O’Hara (Journal of finance, 2004) to study common stock market mechanisms, including open-bid and sealed-bid auctions, as well as the fact that the auctioneer may not be trustworthy. Our analysis shows that open-bid auctions dis-incentivize stock research, leading to higher volatility. On the other hand, we also show that in sealed-bid auctions, the price and volume of an auction reveals only partial private research information, thus retaining incentive for traders to do research. We also show how secure computation can be used to build auctions with a distributed auctioneer, where the clearing and partial-fulfillment information of the auction does not reveal unfilled orders of others, thus maintaining private information

Note: This paper is a new version of the paper ``Upending Stock Market Structure Using Secure Multi-Party Computation'' (IACR eprint 2015/550) with a new title. The main difference is a more finance oriented write-up and an analysis showing that despite public information about the volume of an auction, in addition to the clearing price information, the informed trader is still incentivized to conduct research. In this latest version of Feb 2025, We also provide additional proof that sealed-bid auctions are better than open-bid auctions in incentivizing stock research. Also, the volume information revealed in a (stock-market) auction does only reveal partial information about the bids and asks.