New Breed of Traders Create Stock Market Fragility

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Author Information : Amber Anand (Whitman School of Management, Syracuse University)
Kumar Venkataraman (Edwin L. Cox School of Business, Southern Methodist University)

Year of Publication : Journal of Financial Economics (forthcoming)

Summary of Findings : Using audit-trail data from Toronto Stock Exchange, we find that market makers scale back in unison when market conditions are unfavorable, which contributes to covariation in liquidity supply, both within, and across stocks. Market conditions lower aggregate participation via their impact on trading profits and risk. Contrary to regulatory view, higher stock volatility is associated with more participation and higher profits, even after controlling for other market conditions, including stock volume. Fragility concerns extend to larger stocks, and to active participants. The Designated Market Maker mitigates periodic illiquidity created by synchronous withdrawal of market makers in large and small stocks.

Research Questions : 1. Do market makers act in a correlated manner and withdraw from market making at the same time?

2. Do market makers have an obligation to support the market in reasonable ways during tough times?

What we know : The past decade has seen momentous changes in how stocks are traded in the United States and worldwide. As markets have become electronic, and consequently faster, a new set of market participants has gained increased prominence. These high frequency traders (HFT) have been the subject of much debate and controversy in the markets, but they have come to play an important role as the de-facto liquidity providers in the market. That is, the role of a market maker (a participant who stands ready to sell to buyers and buy from sellers) has largely passed on to HFT firms.

A concern that has arisen as markets have moved from exchange-designated market makers with obligations to reliance on voluntary market making by HFT firms is whether the new market structure has created new sources of fragility. Such concerns became especially relevant after the “flash crash” of May 6, 2010, when the Dow Jones industrial index dropped close to 1,000 points and recovered almost all those losses in less than a half-hour of trading. Then chairman of the Securities and Exchange Commission raised the question that, "The issue is whether the firms that effectively act as market makers during normal times should have any obligations to support the market in reasonable ways in tough times."

Novel Findings : The authors find that market makers indeed tend to act in concert since they respond to similar signals. As expected for profit-seeking entities, the withdrawal is more likely when profit opportunities are small and risk of holding stock inventory is high. In an unexpected result, the authors find that regulatory concerns regarding the impact of volatility may not be where fragility lies. That is, higher volatility actually increases market making profits and consequently increases market maker participation. However, periods of lower volume and one-sided order flow (e.g., more orders to buy than sell coming into the market), when market makers face higher risks and have lesser ability to trade in and out of positions, are associated with market maker withdrawal.

The TSX uses a designated market maker (DMM) who is obligated to provide liquidity in each stock. The authors find that the DMM steps in during these times when other market makers withdraw and reduces the fragility of the market. This result underscores the need for a DMM even in the current market structure. Interestingly, while most regulatory and academic attention has focused on the role of DMMs in smaller stocks, the authors find that the correlated withdrawal problem is also severe for the very largest stocks, and the DMM plays an important role on the days when voluntary market making is scarce for these stocks.

Implications for Policy: The authors’ findings suggest that regulators’ concerns about the new market structure are indeed well founded, and the DMM presents a potential solution to these concerns. While European regulators have discussed introducing market making obligations, U.S. regulators have not yet introduced such initiatives.

Full Citations : Amber Anand, “Market conditions, fragility and the economics of market making” (with Venkataraman, K.), Journal of Financial Economics, forthcoming.

Abstract : The past decade has seen momentous changes in how stocks are traded in the United States and worldwide. As markets have become electronic, and consequently faster, a new set of market participants has gained increased prominence. These high frequency traders (HFT) have been the subject of much debate and controversy in the markets, but they have come to play an important role as the de-facto liquidity providers in the market. That is, the role of a market maker (a participant who stands ready to sell to buyers and buy from sellers) has largely passed on to HFT firms.

A concern that has arisen as markets have moved from exchange-designated market makers with obligations to reliance on voluntary market making by HFT firms is whether the new market structure has created new sources of fragility. Such concerns became especially relevant after the “flash crash” of May 6, 2010, when the Dow Jones industrial index dropped close to 1,000 points and recovered almost all those losses in less than a half-hour of trading. Then chairman of the Securities and Exchange Commission raised the question that, "The issue is whether the firms that effectively act as market makers during normal times should have any obligations to support the market in reasonable ways in tough times."

In a forthcoming paper, Amber Anand and his co-author, Kumar Venkataraman, study voluntary market makers on the Toronto Stock Exchange (TSX) to shed light on these issues. Specifically, they examine whether these market makers act in a correlated manner and withdraw from market making at the same time. Such correlated withdrawal could create pockets of illiquidity in the market.

The authors find that market makers indeed tend to act in concert since they respond to similar signals. As expected for profit-seeking entities, the withdrawal is more likely when profit opportunities are small and risk of holding stock inventory is high. In an unexpected result, the authors find that regulatory concerns regarding the impact of volatility may not be where fragility lies. That is, higher volatility actually increases market making profits and consequently increases market maker participation. However, periods of lower volume and one-sided order flow (e.g., more orders to buy than sell coming into the market), when market makers face higher risks and have lesser ability to trade in and out of positions, are associated with market maker withdrawal.

The TSX uses a designated market maker (DMM) who is obligated to provide liquidity in each stock. The authors find that the DMM steps in during these times when other market makers withdraw and reduces the fragility of the market. This result underscores the need for a DMM even in the current market structure. Interestingly, while most regulatory and academic attention has focused on the role of DMMs in smaller stocks, the authors find that the correlated withdrawal problem is also severe for the very largest stocks, and the DMM plays an important role on the days when voluntary market making is scarce for these stocks.

The authors’ findings suggest that regulators’ concerns about the new market structure are indeed well founded, and the DMM presents a potential solution to these concerns. While European regulators have discussed introducing market making obligations, U.S. regulators have not yet introduced such initiatives. The authors also highlight the often overlooked role of compensation mechanisms in exchange for marker making obligations. Since a DMM has to step in when market making conditions are unfavorable, DMMs need to be compensated for taking on these responsibilities.

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Amber Anand

Amber Anand

Amber Anand is the Edward Pettinella Professor of Finance and Haydon Family Fellow. His research interests include the microstructure of stock and options markets. His current research relates to market design, trading rules, price discovery and trader behavior.
Amber Anand

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