Could Liquidity Itself Shape Fair and Efficient Market Structure?

By Doug Sanzone, Bayes Capital Markets

Originally published on TABB Forum 

There has long been a question of whether regulatory relief should set market structure to ameliorate market deficiencies or whether competitive forces are sufficient to lead to efficient and productive markets. One of the competitive forces that can help today’s equity markets is liquidity itself. Can liquidity serve as the basis for effectively centralizing the fragmented market, and what is needed for fair and orderly interaction of all flow, regardless of source?

Much has been made of the deficiencies in market structure in the equities markets: fragmentation owing to too many venues; predation by HFTs; regulatory arbitrage and incrementalism; the decline in the number of equities listings with attendant volatility; the cost of trading; the inability to access the trade itself.

There has long been a question of whether regulatory relief should set market structure to ameliorate market deficiencies or whether competitive forces, conditioned by technology, are sufficient to lead to the efficiency and productivity markets have experienced in the past. The fact of the matter is that there has always been an appropriate balance between regulation and competition.

That said, one of the competitive forces that can help today’s equity markets, and which has not been sufficiently exploited, is liquidity itself. It is an economic fact that centralized markets, where all buyers and sellers can interact, are de facto efficient: supply meets demand and sets an efficient price.

That is not the case since the demise of centralized exchanges for equity trading – be they either dealer or auction driven. But suppose markets could be constructed in such a way that even though the structures don’t have the ideal efficiency of a centralized market, the underlying driver of markets, supply and demand – in other words, liquidity – was intermediated in as near efficient manner as possible. Here liquidity itself becomes the driver of market structure. 

The question is: Can liquidity itself serve as the basis for effectively centralizing the market, if there are mechanisms to intermediate all the flow, rather than discriminating on the basis of selective types of flow?

This will require a bit of a rethink by market players if a truly effective level of supply and demand is to be achieved. And the rethink required is specific to liquidity: to suspend judgment on “types” of liquidity and see all liquidity as equal – quant, HFT, traditional, day trader, hedge fund. Flow is flow. More is better.

That said, there are legitimate historical reasons why certain types of flow developed in certain ways, and why players did not deem it appropriate to interact with other types of flow given the strategies they were seeking to execute. So what is to be done? What is needed for fair and orderly interaction of all flow, regardless of source, and which will allow all participants to interact on an equal footing are the following:

First, a neutral meeting point, an environment where diverse types of liquidity can interact in an anonymous, fair and orderly manner. This will require a compliance gateway to filter out any possible manipulative activity associated with orders with a very short-term trading horizon along with connectivity to the various important market centers using the latest technology available in order to access any liquidity outside the environment in a low-latency manner.

Second, algorithmic tools to interact with market. That genie is out of the bottle; algorithms will always be necessary to access liquidity in a low-impact fashion with minimal information leakage.

Third, a specialist/market maker to provide liquidity when needed whose motivation is to service order flow by providing liquidity when needed to maintain an orderly market to attract the next order, not to extract maximum trading P&L from each order by using the advantages of better market access and technologies to arbitrage the inefficiencies caused by Reg NMS, and the proliferation of multiple lit and dark trading venues. The execution of flow in this context is not simply agency (though that is the “first pass”) but actually replicates the traditional ability of order-driven market making when naturals do not meet. Here routing is simply not sufficient; but genuine market making providing liquidity as a service to the customer order completes an efficient marketplace.

Fourth, a neutral execution point that simultaneously satisfies all of the conditions above – once the aforementioned conditions are created, liquidity will naturally gravitate toward an environment that will allow orders to interact with each other in a fair and orderly price-time manner, leading to both superior price discovery and liquidity at those prices. This would create an environment that does not merely have access but aggregates the maximum possible liquidity available.

The effect, then, is as near a template as possible for an effective centralization in a fragmented market. A tall order? Not when judged against the criteria of continued market clunkiness and inefficiency.