The SEC should consider whether traders with the “best access” to markets should be obligated to buy and sell stocks to preserve liquidity, Schapiro said today in a speech at the Economic Club of New York. The agency is also examining whether stock quotations should have to stand for a minimum amount of time. Such a change would stop high-frequency traders from repeatedly placing and canceling orders in milliseconds.
“Some could argue that May 6 was an aberration — another perfect storm — and now that it has passed markets have naturally adapted leaving no need for a comprehensive review of our market structure,” Schapiro said. “I disagree.”
Schapiro hearkened back to an earlier era, when some (and I emphasize some) market makers had affirmative obligations:
“In the old manual market structure, the market participants with the best access to the markets — the specialists and the dominant exchanges — were subject to significant trading obligations,” Schapiro said. “These traditional obligations have fallen by the wayside.”
First, a little history. The affirmative obligation to make markets–to “lean against the wind”–was not universal. Yes, NYSE specialists had such an obligation. But NASDAQ market makers did not. Nor did futures or options market makers. Moreover, it should be noted that in exchange for their affirmative obligation, specialists were the beneficiaries of many privileges; I’ll return to this point below.
Also in a historical vein, (a) affirmative obligations are not a panacea, (b) market makers frequently attempt to avoid their obligations in times of stress, and (c) evaporating liquidity in times of stress is driven by fundamental economics, not technology, meaning that HFT-oriented markets are not uniquely vulnerable to this problem: there is, in brief, no Golden Age to which we can return through the waving of the regulatory wand.
These points are best illustrated by the events of the 1987 Crash. The Brady Report documents that specialists were not uniformly acting as price stabilizers. On the 19th, 26 percent of specialists were trading in a way that exacerbated price trends; on the 20th, as many specialists were trading in this way as were leaning against the wind. The Report concluded that the behavior on the 20th reflected the fact that many specialists exhausted their capital on the 19th, which limited their ability to supply liquidity on the 20th:
The limited nature of some specialists’ contributions to price stability may be have been due to the exhaustion of their purchasing power following attempts to stabilize the markets at the open on October 19.
Moreover, even though HFT was not even a gleam in the eyes of its creators in 1987, liquidity suppliers in other markets responded to the intense uncertainty by drastically reducing the amount of liquidity they supplied. Of NASDAQ, the Brady Report said:
During the week of October 19, some market makers formally withdrew from making markets. In addition, some market makers ceased performing their function, merely by not answering their telephones during this period. . . . There were also widespread reports that many market makers, who normally stand ready to buy and sell hundreds and sometimes thousands of shares at their quoted prices, were only willing to fulfill their minimum obligation by buying and selling 100 shares at the quoted price. Another indication of deterioration in market making performance is the withdrawal by some market makers from the SOES [Small Order Execution System] system, thus reducing from 1,000 to 100 the number of shares they were obligated to buy or sell.
In addition, bid-offer spreads also widened during the period.
Interestingly, the Brady report noted that although futures locals had no obligation to supply liquidity, they were “as a group somewhat more aggressive than normal in taking net positions on October 19.” But, this herculean effort also exhausted their capital, and limited their ability to make markets late in the 19th and on the 20th. I can attest, from personal observation, that by the afternoon of the 19th, most locals were out of the pits: they had been yanked out by their clearing firms. Many of the remaining locals were standing with their arms crossed over their badges, to reduce the possibility that somebody would write down their ID on a trade ticket, hoping to win the outtrade lottery.
So: Don’t blame the loss of liquidity during periods of stress on technological innovation. It happened in the horse and buggy days too. Also: don’t expect that affirmative obligations are sufficient to ensure that markets are immune to crashes.
As I wrote in the immediate aftermath of the Flash Crash in May, the no free lunch principle works here. The imposition of affirmative obligations to supply liquidity when it is unprofitable to do so will reduce the return on market makers’ capital. Absent some other compensation, this will lead to the exit of market making capital. As a result of this exit, investors will pay the cost of the affirmative obligation in the form of higher spreads/greater price impact during times when the affirmative obligation constraint is not binding. Moreover, the exit of market making capital will offset to some degree the effects of the obligation: when the constraint binds, market makers will be risking a greater fraction of their capital to make markets during stressed times than they would in the absence of the constraint, but this greater fraction will be applied to a smaller pool of capital. It should also be noted that one of the costs of fulfilling the obligation is that market making capital will be depleted during times of stress, thereby reducing liquidity subsequently (until new capital can flow into liquidity supply).
The previous paragraph contains the phrase “absent some other compensation.” In the old days of the specialist system, specialists had various privileges that allowed them to trade profitably–at the expense of their customers. These privileges were rationalized, in part, as a means of compensating specialists for their affirmative obligations. Again: no free lunch. Investors end up paying for the obligation.
The primary effect of affirmative obligations is to change the pattern of liquidity supply over time. Less liquidity supply in “normal” times (due to the exit of market making capital, or profits that market makers earn from privileges extended to compensate for the costs of the obligations), less liquidity in post-stress periods, and perhaps more liquidity supply in stressed times.
It is possible that this altered pattern of liquidity supply is welfare enhancing. But Schapiro’s remarks, and much of the post-Flash Crash commentary, does not acknowledge the costs of imposing affirmative obligations. Thus, the proper cost-benefit trade-off question has not even been posed, let alone answered.
The old Greenwald-Stein paper written in the aftermath of the ‘87 Crash theorizes that there are market failures during times of market stress, and that there is insufficient liquidity supplied during these periods. But it is not clear that affirmative obligations are the most efficient way to address that problem. Perhaps some other strategy, such as shifting from continuous to call trading during such periods, would be more efficient, especially inasmuch as this does not distort liquidity supply in “normal” times, as the affirmative obligation would.
It must also be recognized that defining and enforcing an affirmative obligation in the current market is much more difficult than was in the case with the NYSE under the specialist system. The “right” obligation is by no means obvious. HFT firms will design their systems to mitigate, not to say evade, the obligation arising under any set of criteria. The details here will be very important, and very difficult to get right.
Another thing that Schapiro mentioned in her speech was the high rate of order cancellations, which she suggested indicate that much HFT liquidity supply is chimerical. To address these, she mooted the idea of a minimum time for which orders must be in force.
Limit orders are short options. Options are costly. Mandating a minimum time quotes must be maintained increases the cost of those options. Market makers will respond accordingly, by increasing spreads and reducing depth. Again, investors will pay. No free lunch, again.
Moreover, this recommendation cuts against the concern that liquidity dries up in stressed times. The option inherent in a quote is more costly when markets are volatile: that’s exactly why market makers reduce their commitments during volatile times. A minimum quote time will make market makers even more reluctant to supply quotes in volatile/stressed times. So this measure, by itself, could make liquidity strikes more likely, not less. To offset this, by imposing affirmative obligations, would result in higher liquidity costs in normal times: the no free lunch principle, yet again. (It would also make enforcement more difficult and costly, as market makers would have a greater incentive to evade the obligations.)
Bottom line: there is no quick fix to the evaporation of liquidity during stressed times. Evaporation is driven by fundamental economic considerations: it is more costly to make markets during volatile periods. Rule changes will not alter that fundamental fact. That fundamental fact holds across trading technologies.
The costs of rules intended to increase liquidity supply in volatile times will be paid for. Period. The only question is when and how. A reasoned policy debate would focus on identifying and quantifying the relevant trade-offs. And it is my obligation to affirm that hasn’t happened yet.
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