Re: Liquidity and Market Makers

["ÁÎ×Ó¹â Henry C.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Liquidity is an issue of substantial interest to pk economists.
As a following up to my previous post on the subject, I draw the list's
attention to the Testimony of Chairman Alan Greenspan
 Evolution of our equity markets
 Before the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate
 April 13, 2000

Greenspan is accused by Senator Jim Benning as having exceed his
legitmate
role a Chairman of the Fed in managing monetary policy and taking
actions to
influence the equity market.  Greenspan continues to insist he has only
been
addressing the structural imbalance of the economy created by the wealth
effect and not specifically targeting the markets.

It is surprising to hear Greenspan describe US powess as American
financial
hegemony.  I guess honesty is the best policy.

Greenspan places heavy weight on the regulation effect on emmigration
which
sounds perilously close to accepting "a race to the bottom"
inevitablity.  The
question is: does fragmentation lead to increased liquidity.  In the
Q&A, if I
understood him correctly, Greenspan thinks that fragmentaion will
increase
liguidity for actively traded stocks and the reverse for thinly traded
stocks.  Thats like saying when it rains, it will be wet, a style of
discourse that Greenspan excels.

Henry C.K. Liu

Greenspan:
I am pleased to be here today to discuss the evolution of our equity
markets
and the appropriate role for policymakers in this period of rapid
change.
Publicly traded equities are a significant source of capital for firms,
and
equity markets are a key part of the process of allocating capital among
competing uses in our economy. Through issuance of equities, firms
enable
broad sets of investors to share in the risks and rewards of economic
activity. The pricing of existing capital assets plays an important role
in
directing investments in new capital assets.

 Today, equities constitute a substantial portion of the net worth of
households, both direct holdings of shares and indirect holdings through
mutual and pension funds. In addition, U.S. equity markets are a
significant factor in the international competitiveness of our finance
industry. For these reasons it is vital that our public policies foster
equity markets that remain
efficient, innovative, and competitive.

 In my remarks today, I shall be expressing my own views and not
necessarily
 those of the Federal Reserve Board. I shall endeavor to set out a few
broad
 principles that I believe should govern the evolution of our stock
exchanges.
 Clearly, however, Chairman Levitt and his staff at the Securities and
Exchange Commission (SEC) have enormous expertise that must be brought
to bear on this issue, and they, along with the Congress, should lead
the way in formulating and implementing appropriate public policies.

 Implications of Changes in Technology
 More powerful and functional computers and newer telecommunications
 technologies, in combination with deregulatory innovations by the SEC,
have

 facilitated the development of new trading venues for equities. These
new
venues offer investors a wide range of alternatives for entering orders
and
executing trades. Some of the new trading mechanisms also offer speedier
executions or greater anonymity, which are important to some types of
investors. Many allow customer orders to be matched directly, without
the
traditional intervention of a specialist or market maker. As alternative
trading venues proliferate and flourish, they have attracted
increasingly
larger volumes from the Nasdaq market and to a lesser extent from the
other
exchanges. This competition among trading systems in the short run has
resulted in market fragmentation ? not all orders to buy and sell
securities
necessarily have the opportunity to interact with one another.

 Concerns that this fragmentation will have adverse implications for
market
 efficiency and investor protection are, as I understand it, the prime
motivations
 for this hearing. The prices established in equity markets, as I noted
at
the outset, are a device through which capital is allocated. Investors
rely
on them in making portfolio decisions. These prices should reflect the
supplies and demands of participants across all markets at a given time.
Fragmentation thus raises questions about the quality and completeness
of
the price discovery process and concerns that investors' orders to buy
and
sell securities may not be executed at the best price or the lowest
cost.
Fragmentation also creates the impression, and perhaps the reality, that
separate pools of liquidity yield a lower volume of liquidity in the
aggregate. Particularly in times of stress, liquidity simply may not be
there or it may not be there in depth.

 But these concerns about fragmentation must be placed in perspective.
Market structures are constantly evolving, and activity shifts in
response to
innovations in trading and the development of new financial instruments.
In
the long run, unfettered competitive pressures will foster consolidation
as liquidity tends to centralize in the system providing the narrowest
bid-offer spread at volume. Two or more venues trading the same security
or commodity will naturally converge toward a single market. One market
offering marginally
narrower bid-ask spreads at volume will attract the business of others,
improving its liquidity further, and reducing that of its competitors.
This,
in turn, will engender an even greater competitive imbalance, leading
eventually to full consolidation. Of course, this process may not be
fully
realized if there are impediments to competition or if markets are able
to
establish and secure niches by competing on factors other than price.

 We need to be particularly careful, however, not to unintentionally and
 unnecessarily undermine sources of the extraordinary franchise values
that
have been built in to our equity markets, a process beginning with the
Buttonwood Agreement of 1792 that founded what became the New York Stock
Exchange.
 Participants in our equity markets have succeeded in concentrating a
great
depth of liquidity that is the envy of other nations and a symbol of the
United States as the world's preeminent financial power.

 Yet our established markets are undergoing profound competitive
pressures
and challenges, which they cannot fail to meet if they are to survive.
The very financial participants they serve are signaling that our
exchanges may soon become noncompetitive, and their centralized
liquidity could drift to
other, presumably far more automated, venues. The Nasdaq, as I noted
earlier, has seen significant volume migrate to other trading systems.
The NYSE and
regional exchanges, too, recognize that investors may increasingly
choose to
execute their trades elsewhere.

 Just as the market provides investors' valuations of the long-term
prospects of individual equities trading on exchanges, the market also
signals its assessment of the values of memberships in the exchanges
themselves. It is
evident from these evaluations that market participants appear to be
increasingly discounting the earnings from seats on the NYSE itself
relative
to the earnings of the stocks that trade on it. Since 1996, for example,
price-earnings ratios of NYSE stocks have risen by half. The ratio of
seat
prices to the underlying earnings from seat leasing has barely budged.
This
clearly implies uncertainty about the future of the exchange. It would
be
unfortunate if this prized institution symbolizing American financial
hegemony allowed itself to become marginalized.

 But if it fails to respond to technological change, one centralized
trading
venue, even the NYSE, can be displaced by another as other trading
systems take advantage of newer technology to offer greater efficiency
or to provide new functions investors value more highly. The transition
process clearly would result in fragmentation ? a necessary consequence
of the process of
competition in the provision of trading services. Obviously, if
fragmentation can be avoided, it should be. But if we enter such a
transition process, it probably cannot be avoided entirely.

 The Role for Policymakers
 What, in general, should be the role of policymakers in this cycle of
competition, fragmentation, and consolidation? We would do well to
borrow
the advice offered to the medical profession and, first, do no harm. It
has
never proved wise for policymakers to try to direct the evolution of
markets, and it strikes me as especially problematic at this juncture.
The
structure of our equity markets is extraordinarily dynamic; hardly a
week
goes by that a new trading venue is not announced or an enhancement to
an
existing system is not trumpeted. None of us can anticipate which of
these
venues will hit upon the combination of services that best meets the
needs
of investors. That can only be revealed as competition establishes
winners
and losers.

 In light of these judgments, I would caution against the implementation
of
a government mandate for any particular form of central limit order
book.
Given the pace of change in our markets, it is difficult to contemplate
how a
government mandate could be implemented; systems might well be obsolete
before we were half-way through the planning process.

 As this technology-led market restructuring process plays out, there is
a
role for policymakers in facilitating the transition to a long-run
equilibrium
market structure. Change often proves controversial because entities
currently
earning above-market rates of return owing to dominance over a segment
of a market will seek, not unexpectedly, to protect those returns. Many
will argue that the rules, regulations, or market practices that give
rise to such niches
are critical for the continued functioning of markets or are in the best
interest of investors. These same entities, however, will see the need
for
additional competition in areas where others are earning above market
returns. It is the obligation of policymakers to cut through this
underbrush and ensure that market participants and trading venues
compete on as even terms as possible and that property rights of
participants be scrupulously enforced.

 This suggests a re-examination of market practices and removal of
current
 impediments to competition. The testimony by market participants over
the
last several weeks offers some suggestions, such as broadening access to
the
system by which orders are routed between trading systems. Clearly, all
market
 participants recommend steps that are in their own self-interest; this,
of
course, is not surprising. However, the role of policymakers is to weigh
the
rationale for recommended practices and use regulatory policy to foster
competition.

 There are other ways in which policymakers can facilitate the shift to
a
new equilibrium market structure through steps to make competition
itself more
 effective. One area in which endeavors could well prove fruitful is
enhancement of the transparency in markets. The SEC's request for
comment on market fragmentation seeks suggestions to improve disclosures
both by market
centers and by brokers about the handling of orders and the execution of
trades.
 Transparency is a fundamental organizing principle of markets. Buyers
and
sellers should be fully cognizant not only of the characteristics of
goods
being bought and sold but also of the costs and methods by which trading
occurs. Only in this way will they be able to signal through their
trading
patterns the market venues that best fit their needs. Retail investors,
in
particular, should pay attention to costs other than commissions that
may be
buried in the contracts authorizing their transactions. Such costs could
include delayed executions, failures to execute, or forgone profit if
there
is no opportunity for price improvement. Disclosure empowers investors
to
make explicit choices about those factors that affect the quality of
trade
executions and ultimately the returns on their investments.

 Investors also should be particularly aware of the liquidity
characteristics of the systems with which they choose to deal. Despite
the recent market volatility, the resiliency of our vastly expanded
trading systems has not been fully tested, and there is a risk of
complacency.

 If investors assume their everyday manner of dealing will always be
possible in stressful conditions, such an assumption is unlikely to be
realized. The Long Term Capital Management episode was a wake-up call to
institutional investors about the risks of dealing in illiquid markets.
The private-sector group that studied that event ? the Counterparty Risk
Management Policy Group ? noted important deficiencies in the risk
management systems of many market participants. Improvements to these
systems should help market participants better assess the possible
consequences of market illiquidity, whether in the equity markets or in
other markets. But liquidity risk is not just an issue for institutional
investors. Retail investors, too, need to evaluate the implications of
their decisions to deal in particular trading systems.
These investors need to exercise caution when dealing in illiquid
markets,
especially on a leveraged basis.

 Conclusion
 In conclusion, I would like to reiterate my confidence in competition
as
the fundamental guide to the organization of our markets. Although
fragmentation has some undesirable consequences, it is an inevitable
part of
the competitive process.
 Fragmentation signals the value investors place on the services and
functions offered by competing trading systems. In the long run,
activity will
migrate to the systems that best meet the needs of investors, absent
impediments to competition.
 In the short run, policymakers should not attempt to anticipate the
outcome
of the competitive process. Rather, they should seek to remove
impediments
to competition and take judicious steps to mitigate the adverse effects
of
 fragmentation through policies such as enhanced disclosure. Investors,
too,
can facilitate this evolutionary process by carefully evaluating the
efficiency of the trading systems they use and the appropriateness of
the trading strategies they undertake.



"??¡Á??? HenryC.K.Liu ?¨´¡èl?¨²" wrote:

> Paul Davidson has made the point that liquidity is dependent on the
> existence of market makers.
>
> There is a debate raging on market structure reform, summarized in an
> article in today's WSJ (Feb. 22 p.C19).
> The debate centers around "the fragmentation of stock trading among a
> growing number of competing exchanges , electronic systems and
> standalone dealers."
>
> Big firms oppose fragmentaion because it disperses volume and threaten
> their customer orders' ability to command fair and consistent prices.
> Tight contact with institutional customer order flow gives big firms an
> advantage in selling other services, such as investment banking.
> They propose a cetral order book with price-time priority for all
> trading systems.
> Retail firms such as Schwab oppose a central book in favor of a network
> of multi links between systems so that it can keep its on-line
> individual traders and its current "internalization" of market markers
> within the firm, calim that a central book would eliminate freedom of
> choice.
>
> The exchanges are divided.
> NASDAQ has been trying to create its own central book.
> The NYSE, as always, tries to have its cake and eat it too. It does not
> want to be forced into a central book with its competitors, but it also
> fears fragmentation of its own centralized market.  Under SEC pressure,
> it has agreed to drop Rule 390 which restricts big firms from sending
> their orders elsewhere.
> The SEC is asking for comment this week for the repeal of Rule 390.
> The political issue is regulation (SEC) vs. deregulation (Senate Banking
> Committee).
>
> The SEC is soliciting inputs from all parties.
> Do PKT scholars have any?
>
> Henry C.K. Liu