the failure of continuous markets bima
DESCRIPTION
Today’s market structure is a complex web of venues, order types, fee structures, participants and regulations, and this complexity has given rise to high-frequency trading. The risk is that, as an industry, we perpetuate an erosion of confidence in the equity markets.TRANSCRIPT
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The Failure ofContinuous Markets
BIMA, Spring 2012Chris Sparrow
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Agenda Where we are
How we got here
Problems with what we have
How can we fix the problems?
Benefits
Workflow
Impact to HFT
How do Venues differentiate?
Issues
Conclusion
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Where we are Todays market structure is a complex web of
venues, order types, fee structures, participants andregulations
Issues such as explosion of market data, trade-throughs, dark pools plague investors trying toefficiently allocate capital
Participants have entered the trading ecosystem toexploit niches created by the complexity leading to
rise of HFTs Natural investorsretail and institutionalhave lost
confidence in the equity markets leading to reducedvolumes, enhanced volatility and fewer IPOs
In short: the market structure is broken
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How we got here Regulations were introduced allowing for
competition of secondary trading venues
(Alternative Trading Systems) Competition was seen as a positive for equity
trading and it was hoped that execution feeswould be reduced and innovation spurred
Idea was good, but there were unintendedconsequences
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Problems with what we have Each lit venue trades on a continuous basis
Quotes can be submitted and/or cancelled at anytime
Trades can be executed at any time There is no synchronization between venues
Potential for latency arb exists and participantshave exploited this
Lack of synchronization leads to a differentialdistribution of information regarding avaialbleliquidity and executed trades Participants can pay for a first-look
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Problems (cont.) Venues are no longer utilities providing a
societal benefit (effcient allocation of capital)they are now for-profit entities serving theirshareholders Competition between venues leads to incentives to
attract liquidity (maker/taker fee structure)
Order types that are designed to attract new
participants Non-trading services including co-location and
direct low-latency data feeds
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Problems (cont). Continuous trading in a non-synchronized
fashion leads to: Race conditions Missed liquidity Trade-throughs Locked markets Latency arb
Technology arms-race Data explosion Quote stuffing/denial of service Technological adverse selection
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How can we fix the problems? Starting point: the raison dtre of markets
To allocate a scarce resource (capital) in an efficient manner Most important participants are Natural Investors (i.e. those
with capital to allocate)
Identify the factors leading to the crisis in confidencethat natural investors have in the market Latency arb and ability to pay for a first look at market data
Proposed solution is to discretize the market: change
from continuous to quantized Physical systems have a minimum temporal resolution (Planktime)
Continuity is a mathematical concept that provides a goodapproximation of reality in certain regimes
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The illusion of continuity
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Fixing the problem Allow all participants time to react
Various participants may receive informationearlier than others but if all are given enough timeto react, then advantage is removed
Remove time-priority in order books, reward size=> liquidity
Require venues to synchronize their
executions and order entry Executions and quote updates all occur
simultaneously, removing potential for latency arb
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Benefits Only one quote update per call dramatically
reduces data requirements
Trade throughs eliminated Locked markets eliminated
Stocks can be halted in co-ordinated manner
Market can be re-played accurately
Technology arms race can be avoided
Volatility based circuit breakers can beapplied pre-trade
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Workflow From t1t2, all trading venues open for order entry
Orders are not made visible to market participants Participants allowed to cancel any open orders while order entry window is open
At t2, order entry window closes for all markets Allow a short time (t2-t3) to ensure all venues order entry windows are closed
(venues confirm closure to each other) At t3, initiate matching process (regulator could provide signal to initiate)
Determine unique clearing price for the current call by having venues compare theirbooked orders
Each venue matches orders at the clearing price (do not allow intra-call time-priority) Cross-venue matches determined as per bi-lateral venue agreements Allow dark orders and crosses to execute at clearing price
Orders that would lock or cross market are cancelled or re-priced Allow passive orders to book in order to attract liquidity to next call
At t4, matching process completes, trades are reported to tape and regulator,passively booked orders reported
At t5, next order entry window opens Lather, rinse, repeat
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Workflow (cont.)
OrderEntryOpens Time
OrderEntryCloses
MatchingProcessBegins
MatchingProcessEnds
Trades& quotesreported
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Workflow (cont.)
Time
Venue 1
Venue 2
Venue 3
Venue 4
All Venues synchronize operations
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Impact to HFT Latency arb is only one aspect of HFT HFTs are very innovative and will find new
niches to replace latency arb Existing strategies may be tweaked but
should continue Stat arb Multi-asset arb Pattern recognition Market making/ELP Other?
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How do ATSs differentiate?
Creating synchronized trading does notpreclude innovative order types,
freedom to choose fee models Latency differential goes away, but
ATSs can still compete in other ways
Example: dark pools in Canada currentlyall have specific niches
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Analogy:Distribution ofMaterial Information
When a company issues material information:
its stock is halted,
the news is diseminated, investors and traders are given time to digest the
news,
the market re-opens
What if price discovery is consideredmaterial?
Apply the same model on shorter timescales
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Analogy: Requiringsynchronization
Entrepreneurs can create new productsthat work with AC current
Product must be able to plug into theexisting electrical grid and consume 60 Hz
AC
Innovations must work within the existingstructure: what if we required tradingvenues to synchronize?
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Issues
Need to apply the model to alljurisdictions and asset classes
Requires co-ordination between venues
Requires new approach to matchingengines need to be changed
There will surely be some unintendedconsequences
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Conclusion
A new approach to trading: abandoncontinuous trading for a series of call auctions
Primary goal is to restore confidence to theparticipants that the market serves: NaturalInvestors, Corporations
Continue to allow competition of venues and
intermediaries (HFT) Avoid transaction tax, technology arms race,
minimum resting times, data explosion
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Questions?