Regulation of Market Makers: An Evolutionary Persistence

Given concerns over “a ‘Houdini’ disappearance of market makers in general”[1] and demands “to increase obligated liquidity in our markets,”[2] one may ponder on the state of the market for liquidity. The market making crisis covering different strata of securities—for instance, high-volume stocks traded on leading exchanges and elsewhere via sophisticated algorithms, smaller-cap stocks representing emerging companies, or corporate bonds traded over the phone and on new electronic platforms alike—also highlights a much broader market structure crisis in the securities industry.[3] The observed multitude of trends and phenomena, such as a further redistribution of liquidity from have-nots to haves, mismatches in the balance of the applicable trading obligations and privileges, and criticisms of high-frequency traders as “fair weather” liquidity providers, points to the importance of regulation of market makers. The term “regulation” is to be interpreted broadly. Indeed, the use of market making regimes by trading venues as a dimension of competition implies a gravitation to self-regulation rather than governmental regulation, although the latter is likely to play a role in market-wide / collective action issues.

While there is no perfect taxonomy for factors motivating a regulatory framework for market makers, my forthcoming article singles out the following key—and sometimes overlapping—factors: externalities in the market for liquidity, vulnerability of these market participants to certain trading strategies, and their own opportunism. From the early days of exchanges to the modern electronic marketplace, the persistence of these factors is fascinating. Meanwhile, the overall regulatory scheme impacting market making has evolved through a myriad of regulatory measures—the Volcker Rule, to name just one—with some of them having specific burdens or exceptions for markets makers as such and others having more general application.

Externalities in the market for liquidity are primarily addressed by balancing market makers’ trading obligations and privileges. Framing this issue as an externality means recognizing the wedge between the socially optimal level of liquidity and the profit-maximizing level of liquidity and designing an appropriate subsidy. In fact, numerous empirical studies indicate that the existence of trading obligations applicable to market makers—coupled with trading privileges—improves market quality.[4] Skepticism over market makers’ trading obligations often relies on examples of market breakdowns, like the infamous Flash Crash of May 6, 2010. The essence of the argument is that an obligation to provide a minimum level of liquidity would require market makers to “catch a falling knife” in volatile high-speed markets. However, these obligations add significant value in stable conditions and potentially prevent self-inflicted / market structure-based crashes, and there are alternative means, such as circuit breakers or special “anti-disruptive” restrictions on trading, for addressing extreme events. Trading obligations of market makers are also actively discussed and utilized in the context of issuer-sponsored compensation arrangements for providing liquidity and support of broader baskets of securities, which revives the historical principle of cross-subsidization.

The very nature of the business of market making, especially when accompanied by specific obligations to provide a minimum level of liquidity, makes these market participants vulnerable to certain trading strategies. This vulnerability of liquidity providers, whether formal or informal ones, largely overlaps with the concept of adverse selection. This concept does not have a universally accepted definition, as it may cover the gamut of scenarios between the risk of entering into an unfavorable transaction with a counterparty with superior information and the risk of entering into an unfavorable transaction with a counterparty reacting to public information, with various interpretations of “superior” and “public.” While the academic field of market microstructure, which often has assumed away key distinctions between different types of informed trading, may see recent developments in securities markets as something novel for the phenomenon of adverse selection, the current environment is not fundamentally different. Conceptually, it is not new compared to, for instance, the practices of “late tape” trading and “tape racing” dating back to at least the 1960s. One may also recall more recent examples of “SOES bandits” and “RAES bandits,” which hardly qualify as true insider trading. Historically, trading venues have taken a number of measures to protect their market makers from adverse selection, sometimes even banning computerized trading as such. However, these measures may be abused, as recently demonstrated by Barclays’ usage of the “last look” feature on its FX trading platform.[5]

Yet another driver of regulation consists of restraints of opportunism. After all, market makers are often in the position to play the role of aggressive traders / consumers of liquidity rather than its providers, and they may be inclined to minimize their presence under certain scenarios or otherwise “game” their trading strategies, as well as their potential advantages. Traditionally, trading venues and other regulators have addressed various manifestations of opportunism by subjecting designated market makers to “affirmative” obligations to stay in and maintain the market and “negative” obligations to refrain from certain trading activities. On the other hand, there have been concerns about informal liquidity providers, such as the floor traders of the past or the high-frequency traders of the present. At the same time, any efforts to outlaw informal liquidity providers, however opportunistic and whether HFTs or otherwise, is bound to be a “red herring” regulatory option. Ultimately, anyone placing a non-marketable limit order is effectively acting as a liquidity provider, and, likewise, many trading strategies may contain a market making element.

The phenomenon of high-frequency trading is of particular significance for regulatory reassessment and reform, as new players, high-frequency traders, are often seen as another iteration of market makers. However, this multifaceted phenomenon does not always fit the traditional definition of market making, and perhaps many forms of HFT are better analogized to older and more familiar practices of “floor trading” and “scalping.” In many instances, HFTs play the role of informal liquidity providers, which raises the issue of their impact on other types of market makers. Moreover, many strategies employed by HFTs actively consume liquidity, amount to parasitic intermediation, or rely on certain “plumbing” features that go far beyond speed and are frequently nontransparent. In other words, an analysis that “focuses on HFTs as liquidity providers”[6] has serious limitations. On the other hand, some HFTs have assumed the role of designated market makers, often supplanting integrated securities firms.

Overall, the vision of an egalitarian marketplace lacking participants with trading obligations and privileges shared by many financial economists, as well as some industry insiders, has proven to be unrealized. Technology and electronic trading in particular, while in many instances enhancing the interaction of natural liquidity, have not made market makers obsolete. One repeated suggestion is that institutional investors themselves should play the role of market makers, given their perceived advantages, perhaps combined with some tweaks to the trading infrastructure, but a disintermediation of sell-side market makers remains to be seen. Another important perspective relates to traditionally manual and less liquid markets, such as those for corporate debt, given the emergence of electronic platforms in that space and demands for even greater investor-to-investor trading. More generally, it is not even a matter of old-school dealer networks versus electronic platforms: the issue is how new electronic platforms could be structured, by contrast to all-to-all classless fishbowls, in order to grant trading privileges to certain market participants in exchange for trading obligations. In other words, the design of such electronic platforms needs, to some degree, to replicate or compensate for traditional dealer advantages.

To sum it up, a range of liquidity commitment devices is needed in order to fix various imperfections in the market for liquidity and essentially spread liquidity around for a broader economic effect rather than for its own sake. Technological developments do not make obsolete the model of dedicated liquidity provision in securities with a range of characteristics, whether in connection with the integrated model or on the stand-alone basis. The current strain on the market making business may be attributed to the disappearance of many advantages traditionally enjoyed by these market participants. Ironically, quite a few of these advantages had been nontransparent and thus often criticized, but their removal has had an adverse impact on liquidity in certain segments of securities markets. On the other hand, there is room for strengthening the market for liquidity through tested and novel means, including the use of transparent advantages for market makers. Navigating between the Scylla of anticompetitive profits and the Charybdis of illiquidity and preserving a viable mix of formal and informal liquidity providers remain necessary for regulatory design.

ENDNOTES

[1] Huw Jones, Regulators Concerned at Banks Scaling Back Market Making Commitments, Reuters (Dec. 9, 2014), http://in.reuters.com/article/2014/12/09/us-markets-regulations-idINKBN0JN1HN20141209 (quoting David Wright, Secretary General of the International Organization of Securities Commissions).

[2] Computerized Trading: What Should the Rules of the Road Be? – Part I: Hearing Before the Subcomm. on Sec., Ins., & Inv. of the S. Comm. on Banking, Hous., & Urban Affairs, 112th Cong. 47 (2013) (prepared testimony of Chris Concannon, Partner and Executive Vice President, Virtu Financial, LLC).

[3] For an extended discussion of the market structure crisis, see Haim Bodek & Stanislav Dolgopolov, The Market Structure Crisis: Electronic Stock Markets, High Frequency Trading, and Dark Pools (2015).

[4] See, e.g., Amber Anand & Daniel G. Weaver, The Value of the Specialist: Empirical Evidence from the CBOE, 9 J. Fin. Mkts. 100, 102–04 (2006); Rafi Eldor et al., The Contribution of Market Makers to Liquidity and Efficiency of Options Trading in Electronic Markets, 30 J. Banking & Fin. 2025 (2006); Johannes Atle Skjeltorp & Bernt Arne Ødegaard, When Do Listed Firms Pay for Market Making in Their Own Stock?, 44 Fin. Mgmt. 241 (2015).

[5] See Press Release, N.Y. Dep’t of Fin. Servs., NYDFS Announces Barclays To Pay Additional $150 Million Penalty, Terminate Employee for Automated, Electronic Foreign Exchange Trading Misconduct (Nov. 18, 2015), http://www.dfs.ny.gov/about/press/pr1511181.htm.

[6] Merritt B. Fox et al., The New Stock Market: Sense and Nonsense, 65 Duke L.J. 191, 247 n.133 (2015).

The preceding post comes to us from Stanislav Dolgopolov, a regulatory consultant with Decimus Capital Markets, LLC. The post is based on his forthcoming article, which is entitled “Regulating Merchants of Liquidity: Market Making from Crowded Floors to High-Frequency Trading” and available here.