There has been a great deal of discussion recently regarding the growth of electronic exchanges and the implications for traditional, physical exchanges. Most of the focus has been on the issues of cost savings and convenience. But there is a far more fundamental function that is sorely in need of attention.
Whether physical or electronic, the primary purpose of any exchange is to provide a forum for market participants to exchange risk capital and, in doing so, reflect a consensus price at any point. This is the notion of price discovery. Notice that it is not the responsibility of the exchange to determine what that price should be (as is implicit in much of the discussions regarding market volatility). That is the aggregate responsibility of the investors, traders and other market participants who use the exchange to execute their trades.
In order to perform this basic function of price discovery most efficiently, the exchange must strive to continuously attract the maximum number of potential buyers and sellers possible, and allow them to exchange capital in an orderly manner. That is, it must establish mechanisms that maximize liquidity. From any market participant's perspective, liquidity is what we ultimately ask of an exchange.
Unfortunately, with the recent advances in investment technology coupled with the massive growth in both the size and concentration of assets being managed, traditional infrastructures still in use today are woefully inadequate to provide this critical element, particularly during periods of stress when liquidity is most desperately needed. (In fact, "periods of stress" could be rephrased "periods of inadequate liquidity" almost without exception.)
In particular, the specialist system, wherein there is a single designated market maker for a security, is in dire need of an overhaul. This mechanism was designed for an earlier time, when the markets were far smaller, information flows were much slower, and the primary need was for intramarket exchanges, such as exchanging shares of GM for shares of IBM.
That is simply not the world we live in today. Technology allows market participants to make decisions on an asset-class basis, such as trading stocks for bonds, in enormous size, and gives them the ability to act on these decisions virtually instantaneously. The problem is these orders are then routed to a system that never was designed to handle this combination of size and speed.
Recall that under the specialist system, when imbalances in order flow occur, the specialist is supposed to commit firm capital to maintain an orderly market. With today's technology, there is a distinct possibility the specialist will face a decision to commit all or a significant portion of the firm's capital on a single trade. It is simply naive to think that when this kind of situation arises, trading will behave in an orderly fashion and liquidity will be maintained.
This technology-meets-tradition bottleneck became obvious as far back as the crash of '87. Any market participant today who has decision-making authority on large pools of capital, regardless of whether they are motivated by active or passive decision schemes, faces the potential of putting liquidity demands on a system incapable of handling them efficiently. In fact, a great deal of time and effort is spent in large investment organizations determining how to adapt their trading needs to the existing system.
Yet, the typical response by the exchanges to the '87 crash and more recent examples of this kind of structure-induced instability is both peculiar and predictable. First, they tend to blame some subset of market participants for causing the problem. This implies (1) there is a right and wrong set of motivations for trading and (2) they can tell the difference. The obvious fallacy here is the job of the exchange is to simply provide a facility wherein customer demands for exchanging capital can be met efficiently, not determining who is right or wrong. Second, they propose fixes (trading halts, collars, etc.) that result in a restriction of access and liquidity. Rather than address the inadequacies of their own mechanisms relative to the demands of market participants, they instead propose solutions that will end up denying the very service they are supposed to be providing their customers. Is it any wonder other alternatives such as upstairs trading and electronic exchanges are appearing?
Blaming others, such as derivatives, is absurd. Derivatives are nothing more than convenient intermediaries in a much more basic process. Market participants increasingly are demanding liquidity quickly for large pools of capital, and they will continue to search for the most efficient means possible, as indeed they should. The bottom line is that as their customers' demands are changing, traditional exchanges are failing to adapt to accommodate those demands. It is ironic securities exchanges, those symbols of a free market, now face one of the harsh realities of a free market: One of the surest ways to spawn effective competition for your service is to ignore the changing needs of your customers.
What is the ultimate answer? The search should focus on the basic problem: With the traditional infrastructures, the existing market-making entities are often being asked to take on more risk capital than they can handle.
As a start, I would suggest looking at the open outcry systems most often used by futures exchanges. Within that kind of system, there is no inherent limit on the number of market-makers allowed to trade in a given market. This allows large amounts of risk capital to be spread among many entities and results in more efficient trading. This would be my starting point to try to answer the question, "How will liquidity be provided when ____ hits the fan?"
Unless the basic infrastructures we use to trade are adapted to meet the changing demands for liquidity made possible by advances in investment technology, additional crashes are not only possible, but virtually guaranteed.
Charles A. "Tony" Baker is investment director in the Wayne, Pa., office of Alpha Strategies Ltd., an investment consulting firm.
