July 15, 2010
By now, most of the world embraces some form of affirmative obligations for market makers. That is good news. At minimum, a firm won't be entitled to market maker privileges without providing some kind of continuous and competitive liquidity.
But affirmative obligations may not be enough. We know now that May 6 was, in ITG's Ian Domowitz's words, "a liquidity crisis," and we hope that meaningful affirmative obligations will lower the odds of another crisis. While no one but the SEC has the detailed data to prove it, a consensus has formed that May 6 was a crisis aggravated, if not caused, by loosely regulated market makers withdrawing liquidity on the bid side. But did market makers also make liquidity demands as sellers, exacerbating price declines?
As we know, market makers are both liquidity suppliers and liquidity takers, and their liquidity supply and demand depends on their risk models and inventories at any point in time. In other words, market makers cartwheel from liquidity suppliers to liquidity takers as their models generate signals, signals intended to keep the market maker's risk directionally neutral. As an example of all of this, GETCO wrote in its June 19, 2009 comment letter on Reg SHO, "Market makers do not have a directional bias on whether a stock price goes up or down. Direction neutrality is inherent in the very nature of market making...Market makers typically attempt to end each trading day with as little risk or position as possible in a given security, i.e. flat...market makers such as GETCO often employ market making strategies that sometimes include removing liquidity..."
Liquidity supply was withdrawn on May 6, but resting bids are only one part of the cartwheel. If market maker liquidity demands exacerbated price declines on May 6, market maker reform must also include negative obligations. Specifically, the public's priority at a price must be restored, and, more important, there must be reasonable restraints on firms deploying "market making strategies that sometimes include removing liquidity..."
Between proprietary data feeds outrunning the consolidated tapes and co-location, there is no doubt that most market makers have time and place advantages over public customers. Because of time and place advantages, the public used to trade in front of professionals at a price. The public's priority at a price must be reinstated to level the playing field for the investing public, and to restore confidence. Registered market makers will complain this puts them at a disadvantage to unregistered market makers, and they will be right. The answer here is to require unregistered market makers to register. JP Morgan recently wrote matter-of-factly, "Some exchanges have products which give clients a faster look at quotes, in exchange for a fee. As a result, some HFTs end up with access to information sooner than institutional or retail investors who rely on more standard venues (such as SIP Quotes)." This is a very clear statement of the fact of a two-tiered marketplace, where time and place advantages are for sale. That they are for sale to anyone doesn't level the playing field, it just puts more professionals on high ground while the public sinks.
Another vital step in restoring confidence is to put reasonable limits on when and how market makers can demand liquidity. Without these limits, meaningful affirmative obligations might, in fact, aggravate price dislocations because the more liquidity a market maker supplies the more it may soon demand as it cartwheels, particularly during volatile markets. It seems a significant - if not systemic - risk for firms involved in 5%, 10% or even 20% of equity trading in the United States to have market making privileges and market dominance and yet be unbounded - everywhere and all the time - in their liquidity demands.
Because of May 6, its clear we need to reform liquidity provision, and the SEC has a unique opportunity to do so. Affirmative obligations are a very important step. The SEC alone has the data to determine whether market maker liquidity demands contributed to the flash crash. If they did, the SEC has a rare chance and a great responsibility to make negative obligations part of long overdue reform.