ABSTRACT: Earlier papers described the concept of satisfaction- or preference-based trading, with optimization of trade matching on the basis of mutual preference. A market structure based on this design began trading listed equities on the Pacific Exchange on January 29, 1999 under the trade name OptiMark. The Nasdaq market plans to begin trading using the OptiMark system later in 1999, followed by the Osaka Securities Exchange and the Toronto Stock Exchange in 2000. A prima-facie benefit of this approach is the ability to specify trading strategies that explicitly account for transaction implementation cost estimates as a function of the trade size.
In this paper, we present the underlying theoretical framework that unites the concepts of preference-based trading and probabilistic transaction cost estimation. In particular, we develop an analytical generalization of the current market structure constructs of market orders and limit orders. We describe a feasible optimization problem whose solution yields optimal preference profiles, given current market conditions (as reflected by the probability distribution of transaction implementation cost) and a trader-specified coefficient of urgency. This enables the seamless integration of the functions of portfolio selection (the purview of modern portfolio theory) and transaction implementation. We illustrate the application of this theory to a prototype trading workstation.
Key words and phrases: electronic trading , fuzzy sets , preference-based trading , securities markets