Streetwise Professor

January 20, 2014

Why History is Useful: Some Perspective on Liquidity Supply in Floor and Electronic Markets

Filed under: Derivatives,Economics,Exchanges,HFT,Regulation — The Professor @ 11:37 am

One of the annoying things about the debate over HFT, particularly related to the quality of liquidity supplied by HFT traders, is the lack of any historical context.  HFT firms are criticized for pulling liquidity suddenly, particularly when volatility ticks up, thereby exacerbating price moves and the impact of order flow on prices.

The thing is, that market makers/liquidity suppliers have been doing this since time immemorial. Liquidity suppliers have always chosen flight over fight.

I’ve written about that in the past (focusing, for instance, on Black Monday).  This recent blog post provides some excellent historical color that illustrates the point quite well.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

Yes, I know Mr. Spanbroek is talking his book.  (The EPTA represents HFT firms.)  But what he writes about the good old days on the floor are accurate.  They were good days mainly for the guys on the floor, who would supply liquidity when it was profitable, but would head for the exits when the order flow was toxic.  Ditto traders upstairs in the OTC markets.  This is a characteristic of liquidity supply and liquidity suppliers pretty much everywhere and always.

This subject always brings to mind a legendary-and I mean legendary-trader, who told me in the early-00s he was all in favor of the markets going electronic because he was “sick of getting raped by the floor.”  About 2 years ago he told me that he couldn’t compete with HFT.  I guess there was a Goldilocks “just right” era in between, say 2002-2007 or so, but the criticisms of liquidity suppliers is a hardy perennial.  And there is some justice to the charges.  The point is that it is not new, and it is not unique to HFT.  It is inherent in the economics of liquidity supply.

And there is no easy policy solution.  A policy intended to fix one problem will just create others.  Again, the problems inhere in the economics of liquidity supply.

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  1. Isn’t the HFT problem, to the extent it is a problem, one of asymmetric information? HFTs pay for the most up to date information while everyone else suffers a 15 minute lag.

    Comment by Ben Wheeler — January 20, 2014 @ 2:31 pm

  2. @Ben-Not a 15 minute lag. Seconds or subseconds, but that’s still enough to give the edge.

    But again, this is not new. Traders paid (through the purchase of memberships) to be on the floor, where they could see the prices before everybody else. Indeed, their time-space advantage was even greater than HFT traders, especially during the “fast market” conditions described in the post I linked to. Market makers have always paid for an information edge based on privileged access to price information. Indeed, that’s exactly why they pay.

    The level playing field market has never existed. The pros always have an edge and will pay up to get it.

    What I try to point out in this post, and what I have tried to point out in other posts, is that the technology has changed, but there is still a continuity between the old ways and the new ways. Paying to see the price first, whether by co-location fees or an exchange membership, is just another example of that.

    The ProfessorComment by The Professor — January 20, 2014 @ 5:52 pm

  3. Considering the amount of resources dedicated to getting there first, would you think there are gains to be made by requiring exchanges to provide the same speed of access to all rather than charging a premium for professionals who gain that fraction of a second? Seems like this would qualify as a public good.

    Comment by Ben Wheeler — January 20, 2014 @ 6:03 pm

  4. @Ben-there are reasons to believe that the arms race nature of being first creates inefficiencies: there is a literature on patent races that makes similar predictions. I would put a little different spin on the issue though. If this is inefficient, an exchange (not a government) that adopts trading protocols that reduce the benefits of being first would have a competitive advantage. There are new entrants that are adopting trading rules that undercut the first-takes-all model. For instance, there are a couple of new exchanges that are offering periodic (but very frequent) batch auctions. This reduces the need for speed. If the efficiencies are there, perhaps these venues will win, or force the incumbents to do the same.

    Alas, the network effects of liquidity always make competition between trading venues problematic. So even if the periodic batch auction is superior, there is no guarantee it will overcome the liquidity advantage of exchanges that offer continuous trading that gives excessive incentives to speed.

    The ProfessorComment by The Professor — January 20, 2014 @ 8:23 pm

  5. Did the legend’s name rhyme with Sandy Ball?

    Comment by Green as Grass — January 21, 2014 @ 9:34 am

  6. Spanbroek is talking his book, and credit to you for mentioning it. Talking his book or no, he makes a good point, and that is that many firms withdraw in the face of uncertainty, most especially when markets are volatile, and have always done so. Go back almost 100 years to the FTC report on the grain trade from the 1920s, which you know well, and see the FTC make just this observation quite a few times in volume seven.

    There are some important differences we need to talk about though between the futures markets and the equities markets in the US. In the equities markets firms can register as market makers and are given a variety of privileges when they do it. They get relief from a variety of short sale restrictions (locates, in particular), they get relief from the kinds of capital requirements everyone else must abide by, and at some exchanges they get trading priorities, not just through order types available to everyone but through specialized order types available just to market makers.

    These kinds of privileges were extended to intermediaries in the equities markets a long time ago. They were designed to make it easier for intermediaries to provide liquidity and, of course, to earn a reasonable profit doing it. No one ever imagined that intermediaries had to be profitable every day, like some firms are today (Virtu, for example). The privileges were extended so that over reasonable periods of time intermediaries were profitable. In exchange for those privileges intermediaries were obligated to do something – not everything, but something – material to provide liquidity, even in extraordinary market conditions.

    Beginning in the late 1990s, equities markets started changing to allow for at least partially deregulated competition. Somewhat mysteriously (well, not really), many privileges stayed in place but almost all obligations were eliminated. By the May 6, 2010 flash crash, market makers had their regulatory privileges but on most exchanges had to do little or nothing to earn them. Formally they had to post a quote, but any quote met their duty. Bids at a penny and offers at $99,999.99 were enough. After the flash crash these stub quotes were (forcibly) repealed, but at most exchanges they were replaced with formal requirements just as gameable.

    The effect of all this is that market makers in the equities markets have important regulatory privileges over all other market participants but are obligated to do almost nothing to earn them.

    Now, it’s important to understand that these privileges extend to the firm itself, not to the strategy. In other words, short sale relief and capital requirements relief extend to everything the firm does under the trading badge it’s registered as a market maker. The firm only has to meet its minimum quoting baselines and then is free to leverage all its regulatory privileges in any passive or aggressive trading strategy it wants to implement – stat arb, liquidity detection and trend trading, liquidity provision, whatever.

    It’s also important to understand that privileges which were granted to ensure firms were profitable over time are now used to ensure firms are profitable every day. 10 or 20 years ago, at least in the exchange-listed markets, intermediaries were most certainly not the most active traders in the markets, and most certainly lost money from time to time providing liquidity. Today, intermediaries are the most active traders in the market and brag about never losing money.

    For all the unanswered phones in the 1987 crash, intermediaries as a group lost a fortune that day (and so Greenspan had to keep them afloat). In the 2010 flash crash, they made a fortune. In 1987 the responsible feedback loop that accelerated the crash came from investors, and in 2010 it came from intermediaries. What explains the difference? The difference is that in today’s equities markets at least some firms use their regulatory privileges for proprietary trading strategies, strategies that have nothing to do with passive liquidity provision, and those strategies ignite “hot potato” trading in certain circumstances, just as the FTC found 100 years ago. Except that today, because of regulatory imprimaturs, those strategies have more fuel than mere panic, including nearly infinite leverage.

    All this is new behavior in the US equities markets, and it is destabilizing. The solutions are simple enough, depending on where you dial your faith in markets. I have a lot of faith in markets, so I believe these privileges should be revoked. Spreads will widen at first, but firms will adjust and competition will narrow spreads to wherever they should be absent government intervention. Firms will be able to compete without having to pay (largely ceremonial) compliance costs to retain their privileges, more barriers to entry will be eliminated, and investors will pay unsubsidized prices for liquidity, whatever they might be. Sounds good to me.

    History is a funny thing, isn’t it? The HFT industry’s enthusiasm for modern markets turns out to include more than a little rent-seeking, at least in the US. Perhaps someone from the FIA can enlighten us about that.

    Comment by Bill Bremse — January 21, 2014 @ 12:39 pm

  7. @Green – nope. Hint: Obama would not be president without him. Not that that was his intent.

    The ProfessorComment by The Professor — January 21, 2014 @ 5:20 pm

  8. Exactly! Finally, an intelligent article with some intelligent comments. Traders ALWAYS paid a big premium to be on the trading floor; right where the action was happening and where they had access to information before anyone else. But, not only that, you couldn’t just pay to be on the floor. I don’t require what all you needed to do to be so privileged to do this, but I don’t think just anybody with money got to be floor traders. Also, “in the good old days” I had to pay a broker hundreds or even thousands of dollars to make a trade for me. Now, I pay less than $10/trade. I don’t care about fractional pennies being made by HFT’s on large trades. So, they’re getting rich. I don’t want to go back to the day when I had to call my broker and pay him big commissions just to make a trade for me. I sure as heck wouldn’t be able to get in and out of stocks the way I do today. So, tell Obama in his minions to keep his big-fat-mitts off of he stock market. I guaranty you some punk computer hacker will figure out how to game the HFT’s, with a laptop and an alogrithm that places and cancels huge orders using a bogus account so fast that it tricks the HTF’s into buying and selling on bad information. Then you can sit back and laugh when the HFT’s cry “unfair”.

    Comment by Fuzzbuster — April 3, 2014 @ 12:53 pm

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