Wednesday, June 27, 2012

 

The Future of Market Makers


Are market makers necessary in mature markets?  I am not sure.
Many futures exchanges have functioned well for decades without designated
market makers. On the other hand, if an exchange would like to be assured
of the continuous availability of buyers and sellers, it should have
registered market makers with serious affirmative obligations.  But if you want
them to assume those obligations you must give them something in return,
preferably something that will not cost you any money, such as modest
preferential access.

Although it doesn't seem to be part of the official explanation of the flash crash of 2010, I am convinced that part of the problem was that the some of the market making computers were turned off; i.e., liquidity disappeared.  And that could happen because high frequency trading firms have driven market making individuals out of the equity market.

Are high frequency traders fair competition?  That depends if you think co-location and the ability to act on orders before they hit serves the purposes of the market.  Markets seem to be functioning well.  There is very little dispute that customers are getting a decent service most of the time.  It is times like the flash crash which call into question the wisdom of having only a few dozen market makers all using algorithms.  If there is another flash crash and its effects last longer than minutes then we will have to make that judgment.  I think it is only a matter on time.

Apparently the SEC is worried, also.

Earlier this month, the Securities and Exchange Commission (SEC) announced new circuit breakers designed to prevent the kind of extreme market volatility that led to the 2010 “flash crash.”
The proposals, which are to be implemented for a one-year trial period on Feb. 4, 2013, include a “limit-up/limit-down” mechanism and new market-wide circuit breakers. Both initiatives lower the thresholds that trigger circuit breakers and shorten the length of trading halts. They also measure market decline using the S&P 500 Index, rather than the Dow Jones Industrial Average.

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