Tuesday, July 21, 2009

Liquidity, or not. The difference between market making and frequent trading

Liquidity is ephemeral. It is there until it isn't, a real chocolate teapot that disappears when it is most needed. I am not sure how much of this has reached main stream media (MSM) but in the trading world this story is huge and it deals with the current liquidity providers high frequency traders.

Let's think about logging into your E*Trade account, with a few clicks you can buy a lot or an odd lot of shares of your latest stock tip. In a few moments you have your confirmation and I wish you great success in your endeavor. This is how trading is done across the capital markets, no? Ummm... no. IPO's, bond trading to cite some examples is not as clean. The imaginary stock trade is facilitated by a market maker. You want to sell, she will buy. You want to buy, she will sell. At least this is how it worked in the old days. A quick aside, the reason there are market makers is that they take a spread on each transaction, the buy and sell offers are a penny to a few pennies apart, thus the market makers is incented to trade as often as possible but not take positions. They act as a wholesaler with an inventory of certain securities that they sell and buy to make a market. BTW, this is lucrative career.

Now though, 70% of the trades are facilitated by high frequency traders. (HFTs)
Now I don't want to beat on Goldman Sachs but they trade their own accounts (Principal) more than the next 6 firms combined. They act as suped-up Hoover running trades and being paid by the exchange to do so. One interesting fact dug out today involved much maligned CIT. The company was bailed out by its creditors, but during the period in which its future was up in the air the stock traded down below a dollar. Who cares, that is expected. Well, except that exchanges will not pay the liquidity rebate of .003 cents per share unless the stock is above a buck. Thus, as it trades around the dollar mark remember that it is not because of a fundamental value, instead it is following the fundamentals of high frequency trade economics.

So we have moved from a visible market mechanism, the bid spread amount to the exchange rebates for HFTs. While it also difficult to become a market maker it is near impossible to become a HFT. You need a space race-sized budget to build up your computer speeds, you need to secure space near the exchange as the trades are done in microseconds, in short you need to be RenTech or Goldman Sachs.

In summation, there are three main points buried in this post:
A) There is a conflict of interest at the exchanges as the exchanges allow these HFTs unprecedented access to the exchange that the lay retail and institutional investor cannot afford or have access to.
B) Is this the best way to run an exchange, through a hidden rebate to HFTs
C) If 70% of the trades are noise, or worse front run trades by the HFTs how much of the assets value is decided by the noise and how much by its inherent value surmised by the efficient markets hypothesis. (EMH)

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