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 unfair!
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
trades?
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 another blow.
Be careful what you wish for!
