Monday, May 10, 2010

Exchanges, liquidity and stock gyrations

The wild swings in US equity markets that were seen last Thursday have generated a lot of talk about the current structure of equity markets and the increased role of automated trading.

It appears that, with multiple exchanges, the closure of some markets may just increase the reliance on more peripheral, less liquid alternatives. The traditional specialist on the floor of the NYSE is no longer a backstop to prevent a collapse in price.

Another notion that's popular with many financial gurus these days is the claim that you can eliminate certain risks to your portfolio with the right strategy of automatic trading and stop-loss sell orders. Again that claim invites an economic question-- if you are getting an insurance policy, who is selling it to you? I believe the implicit answer is, you are counting on the market-maker to insure you by taking the other side of your escape transactions. But the curious thing about such an insurance policy is that the market-maker gets to decide what premium to charge you after you ask to collect on the policy. You just might find that the state of the world when you and your buddies all most desperately want to cash in on your insurance is exactly the time when the premium proves to be ruinously expensive.

But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn't just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks. You battle bots take it". And, they don't

The FT on algorithmic trading.

The FT looks at the regulatory impact.

Larry Tabb, chief executive of consultancy The Tabb Group, says: “We really need to step back and think about centralisation versus fragmentation and who is providing liquidity. It opens the up market to a whole series of questions about how we want our markets to function.”

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