Market making versus the electronic limit order book
Exchanges in India all operate as electronic limit order book
markets. There are no `market makers'; there is just a publicly
visible limit order book. Anyone is free to supply liquidity, by
placing limit orders. The person who places market orders is the
consumer of liquidity: he pays market impact cost. [
the jargon].
Prior to the rise of the anonymous limit order book, there used to
be a great deal of effort on thinking about the market maker. Market
makers played a big role in many old markets. E.g. at the NYSE, the
`specialist' was obliged to provide liquidity. RBI established
`primary dealers' thinking that they would provide liquidity.
These market structures involved complicated problems of measuring
the liquidity provision by market makers, correctly compensating them,
avoiding monopoly power in the hands of the market market, and
enforcing against market manipulation by the market maker. The rise of
the open electronic order book cut through this Gordian knot.
For many years, there used to be a debate about whether the
anonymous open limit order book market (where anyone can provide
liquidity) is better or worse than a market maker market (where limit
orders can only be placed by one or more market makers). That debate
died down in the 1990s with the success of the electronic limit order
book.
Market making on the electronic limit order book
But even on a limit order book, does it make sense to pay one or
more market makers to provide liquidity? The public would be free to
place limit orders, but one or more market makers would be paid to
place limit orders.
The positive argument runs like this. In the life of every
contract, at first there is a lack of liquidity as various market
participants are reluctant to take the plunge and trade on an illiquid
contract. This leads to a chicken and egg problem. Illiquidity
inhibits participation, and the lack of participation is
illiquidity.
From a regulatory perspectives, exchanges might try to make
payments for liquidity provision (or outright turnover) by various
underhand means. If that is going to happen, then it is better to have
this come out into the open.
But there are also important problems that can come out by going
down this route. The resources that an exchange puts into portraying
tight spreads or high turnover could potentially be used to improve
services for customers. Market participants would make wrong decisions
about an investment decision when they see a product as looking liquid
on screen, whereas this liquidity is actually artificial: the screen
would be falsely portraying liquidity. When exchanges compete on
payments to market makers, this can degenerate into a slugfest where
the deepest pockets win.
The artificial liquidity pushed by mercenary market makers would
tend to lull the exchange into complacence. In the absence of market
making, the exchange would run harder to solve problems of market
mechanisms and contract design, and to get the word out about the
contract.
Recent developments in India
On 2 June 2011, SEBI chose to move ahead with the specification of
a `
Enhancement Scheme' (LES).
By these rules, LES is applicable for individual stocks where the trading volume on
the last 60 days is below 0.1 per cent of the market
capitalisation. (How would this be scaled to derivatives such as
currency futures, where market capitalisation cannot be defined?) I
think this makes sense. The LES would be used to kickstart liquidity
when it is abysmal. The moment a small amount of liquidity comes
about, the LES would step aside.
Based on these rules,
announced a program for market making on the derivatives products
recently launched at the exchange: on the S&P 500 and the Down
Jones Industrial Average (launched in partnership with the Chicago
Mercantile Exchange). These incentives are over and above the absence
of charges by the exchange. I was disappointed to see a payment
based on mere turnover. This would give the market maker an
incentive to do circular trading and thus show a lot of trades. But
turnover is not liquidity.
This program came into effect on 15 September. It may matter more
in the coming week, given that new contract series start trading from
tomorrow.
Will it matter? How will we know that it mattered?
Derivatives on the S&P 500 and the Dow Jones indexes have
gotten off to a surprisingly good start, even though there was no such
program. This has perhaps been helped by unusual levels of volatility
in the US after the launch of these contracts.
The early days of a contract can be a rollicking ride and even
after these time-series fall into place, it will not be easy to tell
whether LES was useful in the history of these contracts or not.
Similar thinking is taking place at BSE also: See
BSE's biggest initiative work? by Mobis Philipose in
Mint. The text there -- obligations such as providing
two-way continuous quotes within specified parameters for quote size
and spread -- sounds good, but here also there are payments per
crore of turnover. By and large, the payments being made at BSE look
much bigger than those at NSE.
In the case of BSE, if LES is able to lift BSE out of zero market
share in derivatives trading, even after the six month period has
expired, then it would be a clear proof that the LES helped. So this
experiment is unlike that of NSE where it will be hard to evaluate
whether or not the LES mattered.
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