Paper 2022/451

Improved Stock Market Structure Using Cryptography

Charanjit S. Jutla and Barry Mishra

Abstract

The stock markets have two primary functions, that of providing liquidity and price discovery. While the market micro-structure was mostly ignored or assumed to function ideally for the purpose of asset pricing, O'Hara (Journal of Finance, 2003) has established that both liquidity and price discovery affect asset pricing, and in particular asset returns. Easley and O'Hara (Journal of Finance 2004) have demonstrated that informed investors' private information is not reflected efficiently in price discovery. We argue that the periodic price discovery has both positive and negative consequences for asset returns. In particular, the inefficient reflection of investors' information during price discovery incentivizes them to conduct research. However, this requires that the auctioneer be ideal or fully trusted. In this work we propose using cryptography, and in particular multi-party secure computation, to setup a novel stock market structure that, to a large extent, removes the negative consequences of liquidity costs and periodic price discovery, as well as incentivizes investors to conduct research. Interestingly, the proposed market structure takes us back to the early days of stock markets, i.e. periodic call markets, but with the not so ``trusted'' auctioneer replaced by a decentralized set of parties where no individual party (or small coalition) gets to know the order book.

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.