Liquidity is gone in a flash

20. September 2010 by Herman Brodie

When consumers are made a price offer they are typically provided with the conditions that go along with it, most notably the period the price remains valid. With that knowledge, the individual can decide whether to snap up the product quickly or to take the time and do some comparison shopping. Investors don’t always share the same advantages, even if they too are consumers – of the capital markets. Investors depend upon transparency and liquidity in financial markets, and expect fair and legitimate opportunities like everyone else. Market-makers provide this for stock and commodity exchanges, whether on open-outcry or electronic platforms, and they receive reduced fees and immediate access to the order-flow in exchange for their services. Wall Street’s ‘Flash-Crash’ in early May exposed a form of market manipulation within this system that the regulatory SEC is trying to sort out.

Ever since electronic order-books gained the upper hand in securities markets, market participants have had an easy time in trying to alarm one another with large volume order placements. High quantity bids and offers are sometimes used to feign an interest in a particular market direction even when there is no genuine trading intention. The behaviour is not particularly honest, but the perpetrator of such a ruse is still liable to trade on his sham proposal. For that reason – with the help of more powerful computers and faster trading connections – reaction times have become increasingly faster. Now, some orders appear and disappear in milliseconds; this raises questions about their seriousness. What is the point when the market becomes one big bluff? ‘Quote-stuffing’, as it is known, is now part of the securities industry’s trade lexicon but it shouldn’t be a fixture of daily trading.

A trader known to produce sham quotes, either to influence the price his way or to catch other market participant unawares, is eventually going to have a public relations problem. Accordingly, this kind of behaviour has repositioned itself on the internet, but the practice ought to be curbed there too. Otherwise, investors might be deluded into thinking they are participating in a liquid market and embark on strategies commensurate with that belief, only to discover they are really skating on thin ice. For instance, stop-loss orders – a fundamental tool for any investor – can easily backfire. That is unacceptable. Why can’t exchange members be required to hold a price quote for a minimum time-period? Ostensibly because the exchange would lose trading volume and the markets would lose some speed, but at least participants would be spared another horror scenario like Flash Crash 2010.

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vposted on 20. September 2010 at 2:12 pm

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