The financial press and
alternative investing blogosphere is all abuzz about proposed German controls
that attack High Frequency Trading (http://www.cnbc.com/id/49174317). Government always justifies its coercive
intrusion into markets by appeal to a sense of the "public good",
and its interference never delivers the goodies as advertises (see my
doctoral dissertation for a full explanation of this: A Free Market for Goods,
Services, and Money).
In this article, I focus
on just one aspect of this new control. They are proposing to set a cap on
the ratio of orders to trades. At first, this sounds reasonable.
"Why should anyone have 10,000 orders for every trade that
executes??" This is an appeal to emotion, to make the reader angry at
the thought that this is somehow cheating or unfair.
Let's take a look at a
shadowy and poorly understood player: the market maker. He first
appeared in the London coffee houses where stocks were traded. Sellers
lined up on one side, in ascending order of price (so the best offer (ask)
was at one end). Buyers lined up on another side, in descending order
of price (so the best bid was across from the best offer).
The market maker came in
and said he was ready to buy or sell. He quoted a bid that was higher
than the best bid and an offer that was lower than the best offer.
Virtually everyone was outraged, and many thought this newcomer must be
some kind of criminal or cheater. They were wrong. Their outrage was
fueled because the best bid was topped and the best offer was undercut. How
The market maker earns
his profits by narrowing the bid ask spread. Today, of course, most
people understand this and there are market makers in every liquid market.
What they often don't understand (judging from the strident tone on many
alternative investing blogs) is how he operates. Liquidity does not mean a
willingness to buy from all sellers and prop up the price. Let's not confuse
market making with central banking!
It is not the market
maker's job to bankrupt himself by buying in front
of an avalanche of sellers. When the avalanche does occur, and the market
maker smartly steps aside, the ensuing crash should not be blamed on
him. It should be blamed on the economic climate, the bust phase of the
credit cycle, monetary policy (especially falling interest rates), and the
liquidity crunches that occur due to the rising burden of debt.
The market maker is
working to narrow a simple spread: the difference between the bid and the ask. As the bid from buyers moves or the ask from sellers moves, the market maker must adjust
his bid and ask. The rate at which he must do this depends on the rate at
which others in the market are changing their prices.
Another point worth
highlighting is that sometimes a market is slow. The bids and asks move up
and down, but one can observe no trade for an hour or more. I have
observed this more than once in options on copper futures. In the
morning, I execute a trade. The "last" price immediately
updates on my eSignal screen to show this
price. By the afternoon, the bid and the offer could be a mile away from
the morning. And yet my trade still shows as the "last".
So what will happen if
the regulators force market makers not to change their prices more than twice
a second, or force them to limit the number of orders based on the number of
Some market makers will
be rendered submarginal, and they leave the market
entirely. The survivors will be forced to widen their quoted bid-ask
spread enough to cover the risk of a price movement during a time when they
are barred from changing their prices.
The net result will be
wider bid-ask spreads. Both producers and consumers will experience this as
higher cost, and traders will experience this as higher volatility. Some
traders will profit from this, and the real economy will have to absorb
Be careful what you wish