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Philly, Pa
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Sunday, November 20, 2011

Futures exchanges and stock exchanges were created to justify separate economic needs yet both have been called into question as to whether a genuine service was being provided, or if the exchanges and traders were just redistributing the wealth for the benefit of themselves. Commodity futures exchanges were intended to be a venue for price discovery, risk transference, and price speculation, while stock exchanges were developed as a source for raising capital for extant companies and a co-location for investors who wished to share in the profits of these companies. In both marketplaces, customer orders flowed into the exchanges, where liquidity was provided by market-makers and fair value was determined through the process of price discovery, while price information flowed back to the customers almost simultaneously. Competition among the MMs resulted in narrow spreads and deep markets, which resulted in efficient price discovery.

Decimalization eliminated the majority of market makers willing to provide liquidity in the equity arena, while the end of open-outcry and the migration to electronic trading, eliminated futures market makers. The majority of liquidity is now being supplied by unregulated high-frequency traders, who according to the TABB Group, are responsible for 56 percent of the NYSE’s volume (includes proprietary trading shops, market makers, and HFT hedge funds), while institutional traders comprise 17 percent (mutual funds, pensions, asset managers), hedge funds-15%, and retail-11%. In an Orwellian twist of fate, the business model of the stock exchanges may have been permanently altered as a result of the exchanges going public. Now driven by their own shareholders’ need for returns, capital formation appears to have taken a back seat, as the exchanges roll out new technology to attract even more high frequency traders.

Investors have yet to return in full force since the “flash crash”, leaving the market vulnerable to the machinations of the algo-bots, indexers and other short time-frame traders. In 1960 the average holding period for stocks was 8 years, in 1970-5yrs., 1980-33 mos., 1990-26 mos., 2000-14 mos., 2010-6mos, and in 2011 just a little over 2 mos ( NYSE Factbook). In addition, markets have become fragmented. Mary Shapiro stated, as little as five years ago, the NYSE executed nearly 80 percent of volume in listed stocks. Today, the NYSE executes approximately 26 percent of the volume in its listed stocks. The remaining volume is split among more than 10 public exchanges, more than 30 dark pools, and more than 200 internalizing broker-dealers. 30 percent of volume in U.S.-listed equities is executed in venues that do not display their liquidity or make it generally available to the public.

The trader initiating a transaction is said to demand liquidity and the opposite side of the trade supplies liquidity. Liquidity demanders place market orders and pay the spread, and liquidity suppliers place limit orders and earn the spread. The algorithms that drive high frequency trading respond quickly to order flow and price . Quotes are revised in response to trading, and trading is done in response to changes in quotes, giving rise to a two‐way dynamic relationship between the two events.

Algos can easily take into account common factor price information and adjust trading and quoting accordingly, moving away or cancelling existing bids and offers. Other algos are designed to identify order flow and other information patterns in the data and react in the same way or shut down altogether. Liquidity demanders will wait until the supply of liquidity is ample, therefore, volatility is more often a result of liquidity being pulled by suppliers e.g., the flash crash, than an increase in buying or selling that demands liquidity.

Markets tend to function well when a sufficient number of diverse investors interact (liquid markets), and they tend to become fragile when this diversity breaks down (illiquid markets). In an illiquid market weak hands will act in concert, and take the same position based on the observations of others; independent of their own. This of course, leaves them vulnerable to getting blindsided by predatory traders and parasitic algorithms. The attendant volatility and velocity of current moves, along with the absence of follow-through, is evidence of this phenomena. In spite of the Fed’s almost daily injections of liquidity, headline risk regarding sovereign debt spreads continues to embolden the strong hands to pull liquidity when they sense the timing to be advantageous. The bulls have stepped up to the plate and continue to bring the market back each time, like a game of Pong, but professional money is still short. They continue to blame the volatility on Euro-uncertainty, but it is simply the flag of convenience under which they sail, and the corollary of their self-interest and bias. It also the reason why they will continue to do it.

Market structure continues to evolve at a rapid pace while traditional market practices quickly disappear. Obligations to provide liquidity and restrictions prohibiting practices that would disrupt market stability are disappearing, which gives rise to some very relevant questions.

Is the market more (evolving)or less (devolving) efficient now?

Is high volatility caused by a lack of liquidity, or is the lack of liquidity caused by high volatility?

Does higher volume mean greater liquidity?

What happens when HFTs make up 80% or 90% of the volume?

What happens if the market continues to fragment?

Should liquidity providers be allowed to pull liquidity completely?

Is attendant volume still valid as a metric of price action?

What happens when the average holding time for stocks is a a day?

Should there be a transaction Tax for HFTs?

What does the increased velocity of price moves mean for price discovery and market stability?

Is price discovery nothing more than a negative feedback loop?

Are the major equity indices just a de facto measure of the money supply?

Is the Volker rule to be blamed?

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