We seldom get a chance to design stock markets from scratch; to sit at a drawing board and sketch the architecture of what will become a marketplace for the listing and trading of financial securities. An exchange is a complex system that involves many stakeholders with interests that are at times aligned and at other times not. And perhaps the making of exchanges should join those of laws and sausages: something that the rational amongst us should not witness.
But if we are lucky enough to be present at the conception phase of a stock market, the type of microstructure it should have would be at the top of our priority list. Simply put, an exchange’s microstructure determines what is to be traded, who can do the trading, and how that trading is to be conducted. Ceteris paribus maximizing liquidity is the main goal of such designing efforts.
Attributing the success of an exchange to one or more aspects of its microstructure is tempting but can be misleading, especially since experts do not agree on optimal design of an exchange. However, the ability of an exchange to attract listings, investors and intermediaries is impacted by the type of microstructure it has.
A key question in microstructure is whether or not to have market makers in place. Market makers are one of three types of intermediaries present in an exchange. The other two are dealers and specialists. Dealers use their proprietary books to trade; market makers function as dealers but have obligations to provide liquidity; and, specialists provide liquidity for certain securities only.
Market makers are participants in quote-driven securities trading systems that fulfill the function of generating bids and offers. They enhance liquidity by consistently quoting buying and selling prices and, as a result, ensure the existence of a two-way market for the securities being traded.
Part of the importance of market makers stems from the fact that liquidity is asymmetrical; it tends to be high in times of strong demand for securities (bull markets) and tends to dry up when everyone is selling (bear markets). Market makers are obligated to make a market in a stock or security by buying and selling from their own inventory when orders to buy or sell that stock or security are not available by other market participants.
Exchanges differ in terms of formally assigning liquidity roles to intermediaries and there seems to be no rule of thumb to this. Some markets believe that automatic order matching is sufficient. Other markets with large numbers of small cap stocks that tend to be thinly traded benefit from formal intermediary roles in enhancing liquidity. Yet a third category of markets end up with hybrid situations whereby automated order-matching systems are used along with dealer systems. Paradoxically, market makers are more common in developed economies where exchanges tend to be more liquid than those in emerging or frontier markets. Theoretical explanations for this tend to focus on the kind of financial muscle needed to market make and the inclination to avoid liquidity traps: intermediaries are not easily lured into a liquidity provision function when the overall market is relatively small and the financial resources needed cannot be easily had.
However, it is more probable that the presence of market makers in developed economies has more to do with the history of stock market development in those countries than anything else. Additionally, the absence of market making in emerging or frontier markets is decried more often than not by participants, especially intermediaries, in those markets.
Market making has its costs. And the question that begs an answer these days is whether it is worth having market makers given that advances in automated and electronic trading systems have practically rendered their function obsolete. Regulatory developments have led to the unbundling of exchanges and this along with advances in technology has encouraged the creation of alternative trading environments in which buyer and seller can easily find each other and transact directly with limited use for intermediary services and little justification for incurring their costs.
Market makers often have to buy large quantities of securities during a bear market that they can only sell at a later time and this might cause them to suffer losses. As a result, exchanges and regulatory bodies tended to grant certain privileges to market makers. These have included the right to trade in a dual capacity (principal and agent) and to execute large orders away from the trading floor (block trades). And these privileges translate into costs: costs of market making in terms of higher spreads; costs of potential price collusion; and, costs related to the potential lack of transparency of the order book.
The size of the bid-ask spread is a measure of liquidity across markets and warrants some attention. Spreads have three components:- Order Processing Costs: The labor, communication, clearing and record keeping costs of a trade. This is a fixed amount per trade and spreads decrease in value as trade size increases. Electronic trading systems help achieve significant reductions in order processing costs.
- Inventory Control Costs: The assumption here is that a market maker has an optimum inventory level and that any trade that moves the inventory away from this level increases the market maker's risk. The market maker is compensated for the increase in risk. As a result, inventory risk cost is directly proportional to trade size, market price, and price volatility. It is inversely proportional to trading frequency.
- Adverse Selection Costs: These are due to the presence of informed traders in a market and market makers tend to incur losses on trades with those traders and seek to be compensated for this.
Higher levels of liquidity attract additional listings, investors and intermediaries. However, the liquidity advantages of market making must be weighed against the costs incurred in the process. Additionally, for those exchanges in emerging or frontier markets, the ability of regulatory bodies to effectively address potential price collusion and order book transparency issues has a considerable impact such costs.
*In collating these notes I benefited from the works of exchange experts that are too many to mention. I am grateful to all of them.
