The Quality of Price Discovery and the Transition to Electronic Trade: The Case of Cotton Futures

This paper studies the effect of electronic trade on the quality of market price discovery, using the Intercontinental Exchange (ICE) cotton futures market as a laboratory to measure market quality under periods of floor trade, parallel floor and electronic trade, and electronic-only trade. Using random-walk decomposition methods pioneered by Hasbrouck (2007), we decompose intraday variation in cotton prices into two components: one related to information about market fundamentals and one a “pricing error” related to market frictions such as the cost of liquidity provision and the transient response of prices to trades. We describe the properties of this pricing error to characterize market quality under both floor and electronic trading systems. Unlike previous studies, we analyze more than the average magnitude of the pricing error. Each day, we calculate statistics that describe market quality on that day, and we study their trend, variance and persistence.