Computerized market makers should be required to trade futures contracts in good times and bad in order to ease turbulence during a crisis, according to a study sponsored by the U.S. industry’s regulator.
High-frequency traders, firms capable of buying and selling in millionths of a second, are more likely than manual traders to leave markets in volatile times such as the 2008 financial crisis, according to the study. About 61 percent of all trading in U.S. futures markets is now done by these firms, according to Tabb Group, and the paper suggests their exit could leave markets without enough buyers and sellers to operate effectively.
“In the current anonymous world, there is nothing holding back traders and liquidity suppliers from running away,” Pradeep Yadav of the University of Oklahoma, one of the authors of the study sponsored by the U.S. Commodity Futures Trading Commission, said in a phone interview. “They can’t just be fair-weather friends. There needs to be some framework of affirmative obligation to make a market in those times.”
The study’s recommendations are being made as the CFTC examines how the U.S. futures exchanges it regulates reward market makers that trade contracts based on everything from interest rates to foreign exchange and lumber. With trading now conducted by anonymous brokers, firms have less trust in the market and are faster to exit, Yadav said.
Yadav, who wrote the study with CFTC economist Michel Robe and Vikas Raman of the Warwick Business School, said companies that operate the markets should take the first steps to address the potential problem.
“I would rather encourage bottom up than top down,” he said.
The paper, released on May 29, could help explain a number of market anomalies, including the flash crash of May 6, 2010, when the Dow Jones Industrial Average posted an almost 1,000-point decline in a matter of minutes, according to Yadav. A report on the crash by the CFTC and the U.S. Securities and Exchange Commission found that high-frequency firms, which normally buy and sell at about the same rate, contributed to the sudden downturn by mostly selling.
The study’s results show that while manual traders bought and sold more during volatile periods, increasing their trading volume by over 13 percent, high-frequency firms left the market more fragile by reducing trading by more than 9 percent. The paper looked at crude oil futures contracts on the New York Mercantile Exchange in 2006, 2008 and 2011.
High-frequency traders can use market information to see big swings coming, Yadav said, and may slow trading to avoid the fallout. Manual traders worked with each other over the years and can trade with the confidence that they wouldn’t often give each other bad deals, according to Yadav.
“You can be a smart aleck once, but people will remember that,” Yadav said. “If you are smart aleck, they will charge you higher spreads when they trade with you.”
The authors’ proposed solution, a required market maker system in futures markets, resembles the designated market maker system on the New York Stock Exchange. Designated market makers, who replaced human floor traders known as specialists in the mid-2000s, are required to offer trades at the national best price at least 15 percent of the time in the stocks for which they’re registered, and are compensated with higher rebates by the exchange. Futures exchanges have generally not mandated buying and selling by market makers.
Though the CFTC will probably take a look at the proposal, they may not have a lot of options to push market makers to take trades they don’t like, according to Darrell Duffie, a professor at Stanford University.
“I don’t know how seriously the CFTC will take this,” Duffie said in a phone interview. “You shouldn’t assume this is a direction they’re heading. This is just three guys that think this might be a good idea.”
Rules forcing some firms to trade in tough times might impose too great a cost on traders, according to Craig Pirrong, a professor at the University of Houston.
“They’re saying that, ‘Hey, these guys find it really costly to offer liquidity in those sorts of market environments,’” Pirrong said in a phone interview. “So if you force them to offer liquidity in those sorts of market environments, that’s going to force them to bear that cost. It’s not immediately obvious if that’s the right kind of trade-off.”
Brookly McLaughlin, a spokeswoman for Intercontinental Exchange Inc., owner of ICE Futures U.S. and NYSE, declined to comment on the paper. Michael Shore of CME Group Inc., which owns the Chicago Mercantile Exchange and the New York Mercantile Exchange, said his company had no reaction to the study. In 2011, CME’s former chief executive officer, Craig Donohue, said obligations on market makers weren’t necessary, and that “they generally don’t work.”
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