Moving Markets, Making Money: Market Intermediaries' Influence
Abstract:Stock markets can be volatile, to the benefit of certain traders. With greater sophistication of market players armed with clever algorithms and computational powers, how they trade and profit impacts market stability and confidence. In new research, SMU Cox Finance Professor Kumar Venkataraman and co-author Amber Anand push the debate about high-frequency traders' or proprietary traders' impact on market stability and the value of the "specialist" market maker. Regulators are grappling with serious questions about liquidity in the market, especially in light of stresses like the Flash Crash of 2010.
Stock markets can be volatile, to the benefit of certain traders. With greater sophistication of market players armed with clever algorithms and computational powers, how they trade and profit impacts market stability and confidence. In new research, SMU Cox Finance Professor Kumar Venkataraman and co-author Amber Anand push the debate about high-frequency traders' or proprietary (“prop”) traders' impact on market stability and the value of the "specialist" market maker.
Two types of traders or market makers that provide liquidity to stock markets are important to understand —designated market makers known traditionally as "specialists" and another class which describes the strategies of many high-frequency traders. The authors show that proprietary trading desks provide liquidity to the market mainly when it is profitable for them, for example, in large cap stocks similar to S&P500 Index stocks. But they tend to vanish from the market in times of stress. Sometimes they add to market imbalances and worsen a problem.
Regulators are grappling with serious questions about liquidity in the market, especially during times of stress and its impact on market quality. They are also concerned about traders' (proprietary firms) obligations to enhance market quality or at least do no harm when markets are stressed.
The Flash Crash of 2010 sent U.S. regulators scrambling to find out what really happened. High frequency traders (HFTs) withdrew from the market in droves, and the market dropped about 10% in a matter of minutes. "If institutions build their strategies based on a level of liquidity, but if the liquidity can quickly vanish, can markets function in an orderly manner?" asks Venkataraman. "Mini-crashes are observed in markets around the world. But what causes them? If [a market decline is] based on fundamental news, that’s OK. But if it is driven by vanishing liquidity, then it poses a problem and hurts investor confidence. Market declines that are followed by almost complete price reversals similar to the 2010 Flash Crash reveals serious flaws in market structure that need to be addressed."
The authors study the behavior of two important classes of market makers trading in the same stock. From a proprietary Toronto stock-exchange database, the authors analyzed detailed information on the counterparties to a specific trade. They sought to understand when designated market makers, the specialists, and 'other' liquidity providers (the class of liquidity providers that includes proprietary traders and HFTs) trade and what drives their trading decisions.
Order flow or no?
The investment ideas generated by a portfolio manager at traditional mutual funds creates a need to trade. A large buy order from a buy-side institution is eventually absorbed by a large sell order from another buy-side institution. However, in most markets, the trading process of buyers meeting sellers is through intermediated market makers, such as NYSE specialists or proprietary trading desks who commit their own capital.
"Proprietary traders are not that different from exchange-assigned specialists," says Venkataraman. "They are both motivated by profits, make markets using own capital, and actively manage inventory." Venkataraman explains that HFTs use algorithms that detect future imbalances and therefore future price movements. When buy orders exceed sell orders, the stock price is likely to rise. HFTs buy on this signal and in doing so reduce imbalance and supply liquidity. Their holding periods are exceedingly short, in many cases not exceeding ten seconds. Some proprietary desks might hold positions for an hour but by end of the day they have sold all their inventory.
An important distinction however, specialist market makers have exchange-imposed obligations, while the HFTs have no such trading obligations. HFTs implement market-making strategies because it is a profitable activity. The authors write: "In contrast, stock exchanges can create a class of intermediaries, typically described as designated market makers or specialists, who have specific “affirmative” and “negative” obligations imposed to a varying degree by the exchange. The specialists are contractually obligated to maintain a market presence by continuously posting quotes with reasonable depth." This means they must be in "play" regardless of how the market is behaving, whether volatile, erratic, moody, up or down.
In early 2000, when the NYSE was the dominant exchange, the NYSE specialist was the centerpiece of the action. "In the last decade, the NYSE market share of trading volume has dropped from 80% to 20%. The specialist is no longer relevant," Venkataraman explained. "Much of the action occurs in alternative trading venues. The dominant market makers today are HFTs, who participate because it is profitable to do so. More importantly, they can withdraw when it is not profitable since they have no obligations. Does the option to withdraw increase market fragility? That’s the central concern for regulators today," he notes.
Do markets need specialist market makers?
The HFTs —the contemporary market makers without obligations—account for 55%-60% of trading volume in many markets. They are involved in a high volume of trades, and there are relatively few HFTs that are dominant. They have improved liquidity in markets with respect to traditional measures of liquidity. "However, the market is trading on a daily basis with the assumption that these players are in play," says Venkataraman. "When market conditions signal increased uncertainty, whether it is volatility or imbalance—and market making becomes risky—HFTs are likely to withdraw. In fact, instead of supplying liquidity, HFTs may trade in the direction of market instability because it is profitable to do so. This can amplify the uncertainty, which were some of the lessons from the 2010 Flash Crash."
The study finds that proprietary traders are active in large stocks and supply liquidity. In low capitalization (small cap) stocks, under market conditions when profit opportunities are small or inventory risk is substantial, they tend to withdraw participation. Under these conditions, specialists earn smaller trading profits, assume higher inventory risk, and commit more capital. This suggests that the contractual obligations require the specialist to participate in undesirable trades. The study concludes that a specialist is not only an incremental liquidity provider but also the only reliable counterparty available for investors in smaller cap stocks.
"In many cases, the market conditions when HFTs and prop traders withdraw from the market are the exact situations when investors have a real need to buy or sell the stock,” Venkataraman notes. “In light of the liquidity risk, investors are less likely to invest in stocks, or pay a lower price when they do so. For this reason, corporations need to pay attention to stock liquidity. In many markets, the corporation directly enters into a liquidity agreement with market maker to improve liquidity. This concept of 'investment' in liquidity is a positive net present value project, similar to other corporate investments. Such agreements are illegal in the U.S., but there is a recent bill in Congress to allow for such agreements. Our results are supportive of a movement in this direction for low capitalization stocks.”
Venkataraman questions the fragility of the current market structure. "The most active liquidity providers in equity markets today, the HFTs, have no obligations to be around when markets are stressed, states Venkataraman. "Does this arrangement increase market fragility? Does it reduce investor confidence, and if so, what can we do about it?"
The authors document that HFTs and proprietary traders are active in large, liquid stocks, but not small, illiquid stocks. "Outside of large caps, their participation declines quickly," concludes Venkataraman. "The ability to withdraw participation by a dominant liquidity provider introduces an additional layer of uncertainty, particularly at times when markets are stressed."
The research compares and contrasts the specialist market makers who have exchange-assigned trading obligations and other liquidity providers who do not. It identifies market conditions when one group is active and the other inactive. Ultimately, the authors shed light on the true value of a market structure with market maker obligations. Venkataraman remarks, "If you impose obligations on specialists to trade at unprofitable times or in less profitable stocks (because the HFTs will compete with them when it is profitable), we need to figure out how specialists should be compensated for the liquidity services they provide."
The paper titled, "Should Exchanges Impose Market Maker Obligations?" by SMU Cox School of Business Finance Professor Kumar Venkataraman and Amber Anand of Syracuse University. Venkataraman is also Finance Department Chairman and Fabacher Endowed Professor of Alternative Asset Management.
Dr. Venkataraman will present his findings to the Securities and Exchange Commission (April 25) and Commodities Futures Trading Commission (April 26).
Written by Jennifer Warren.