Gene,
The first "assumption" with which you disagree was a statement made in a context that cannot be discarded. To summarize, I was making a distinction between a collective obligation for MMs to maintain an orderly market and the lack of obligation for any single MM to take it upon himself to do so. There is, as far as I know, no rule that governs the actions of any single MM in any market with regard to the prices he chooses to quote, and that is the point of the statement. How he handles orders received at his quoted prices is regulated, but how far and how fast he moves his quotes away from the inside market is left to his own discretion. And as long as somebody is willing to maintain a "reasonable spread", even if it is thin, no regulator is going to complain about the collective effort. If I'm wrong about that, by all means enlighten us. Your observation that MM's are not specialists... they don't have the whole book to themselves only serves to substantiate my premise. There is no passing the buck for a specialist. He is the one guy who has to stand up and take responsibility for maintaining order. What then does it say about how well MMs are collectively living up to their obligation to maintain order to argue that one specialist can do it better?
While I will agree that the larger stocks in the NASDAQ maintain order 'by themselves' due to their extreme popularity and liquidity. However, you can't have it both ways. If you went to a unified ECN setting (which is what you suggest when you question why have MMs in the first place), what do you do with thinner stocks? While I will agree that the larger stocks in the NASDAQ maintain order 'by themselves' due to their extreme popularity and liquidity. However, you can't have it both ways. If you went to a unified ECN setting (which is what you suggest when you question why have MM's in the first place), what do you do with thinner stocks?
I never suggested that MMs should be eliminated in favor of a unified ECN, or for any other reason. I recognize the legitimate and important function of market making, and have publicly stated that MMs DESERVE to be compensated for true making marking activities. As for trading, they don't deserve to be compensated any more than I do, and I see no reason why they should be able to pass off trading as market making. More on that later.
You make it sound as if no MM is printing stock during a panic run up or down.
That's a bit of an exaggeration of what I said, and no doubt what I said was somewhat exaggerated too. Obviously, there are prints on the way down, even when a stock plummets, or else there would be a clean gap. I don't doubt that many of those prints involve MMs. It's a matter of degree, so let's not forget that the case I cited involved no event to stimulate the market other than the sudden lack of bids. There was no news, no block trades and no significant volume to precipitate the event. The question is how much MM activity and what kind of activity is appropriate, and who decides what is appropriate, a MM who is not making a market but is trading instead? If I may quote you: I also like to consider myself a trader first and a market maker second That statement suggests the two are separate things in your mind too. If I extrapolate that preference to all the other MMs trading the same stocks, I see an inherent conflict of interest. When the choice is between providing liquidity to add stability at a fair markup price, and letting the market free fall to a level that optimizes profits, what is the average MM going to do? What should he do?
Did you know that Charles Schwab and Knight Securities have AUTOMATIC printing systems designed to give their MARKET ORDER customers the current bid/offer (up to a size limit) on their order flow? I know people at both firms who have gotten absolutely DESTROYED making markets by standing in there and getting 'automatic'ed until their ears bleed! If Schwab and Knight do it, can you imagine what Morgan Stanley and Goldman Sachs have to do?
I'm very aware of these arrangements (though I don't see them as particularly relevant to my original premise). In fact I have a small trading account with one broker that has had 2 separate arrangements with 2 different wholesaler firms (2 of the major ones, you know who those are) to handle client orders. My broker accepted no payment for order flow but provided a direct electronic link to the MM for their customers. Neither of those arrangements lasted more than a week. Both were terminated by the MM firms because my broker's customers were "too good".
Autoexecution arrangements are not obligatory. They are offered by MM firms who want the order flow as way to generate more business. If they profit from it, they are happy and continue, and if they don't they terminate them, selectively, cutting off groups of clients who can use it to their benefit and keeping the ones that are making them the most money. There's something about the notion of free and open access that doesn't quite fit here.
This practice is also somewhat controversial from another standpoint. A credible argument has been made that this is a form of "stepping in front" of other market participants in that an MM who autofills prevents his client's orders from going to the originator of a superior quote, denying that originator a fill without ever posting an equal quote in the marketplace. (I realize the phrase in quotes has another connotation regarding a certain prohibited activity; I'm not suggesting this is the same thing) Do the Morgans and Goldmans do this for their clients? I really don't know, but I'll bet they shut it off in fast markets like the wholesalers do. If you know MMs who were getting creamed by autofilling, I'm sure some adjustments have been made to prevent it in the future.
IMHO, the system works just fine. It sounds like you expect MM's to sit there and absorb the public's losses.
IMHO, the system works just fine when the MMs are making markets, taking a fair markup on the stock that passes through their hands from one external entity to another. When they turn into traders in an effort to make gains for their own accounts far in excess of the spread they are entitled to for true market making activities, the system breaks down. My original post was an example of one such breakdown. I don't expect MMs to sit there and absorb the public's losses, but that cuts both ways. The public is not there to absorb the losses of the market professionals, or to provide an endless source of revenue to be bled off to ensure that market professionals turn a trading profit. The notion that because an MM firm is a business, that above all else, including it's responsibility to maintain an orderly market, it must make money is ludicrous. Businesses run by people who know what they are doing make money. Those who don't, or run into some bad luck lose money. Just like the public, MM firms need to take responsibility for their business decisions, earning rewards for the good ones, and suffering losses for the bad ones.
Regarding a largely capitalized stock moving 10% in 10 minutes on what you consider 'light volume'... I can guess that the float is thin and the stock is known to be extremely volatile. The more volatile the stock is (we can use the implied volatility measure that options traders use), the MORE drift you are going to get when the volume is light.
I would consider your guess to be rather off. 45 million shares with a float turnover on the average every 30 to 40 market days is certainly not a behemoth like a WCOM, but it's not a viper that gets turned over several times in a day under momentum trading either. As for using volatility as a measure of whether such a sudden move is reasonable, that's a chicken and egg argument. Volatility comes from somewhere. It can come from public frenzy with everyone chasing momentum. It can be triggered by news (EMLX anyone?), and it can originate because investors are fickle and change their minds, loading up and dumping substantial amounts of stock. None of those appear to fit the example I gave. It can also be stimulated by MMs turned traders who stand to gain from it at the expense of the public, and who have much greater resources to utilize for that purpose. So far I haven't heard anything that explains the extreme example I cited, just that MMs have a hard job and need to make money somehow. And so far I've not heard your take on what the difference is between market making and trading.
And your suggestion for ALL of the markets would be?
Well it wouldn't be anything as extreme as you might think from our little debate. It does not include lynching market makers or eliminating them from the system. Without access to all the internals of the MM's realm, I'm not stupid enough to presume I have all the answers, but at a minimum I would explore ways of clearly separating trading activities from what I consider to be a true MM function. Make all the money you can as a trader, but don't do it using the tools that are intended to smooth out the fluctuations caused by external market forces to instead create volatility in order to fool investors into panicked reactions.
Dan |
