Regulating Merchants Of Liquidity: Market Making From Crowded Floors To High-Frequency Trading

Stanislav Dolgopolov

Decimus Capital Markets, LLC

October 21, 2015

University of Pennsylvania Journal of Business Law, Forthcoming

Abstract:

This Article develops a framework for analyzing the very existence of regulation of market makers and singles out such key forces as externalities in the market for liquidity, vulnerability of these market participants to certain trading strategies, and their own opportunism. This framework is explored through the evolution of the market making segment of the securities industry from crowded floors to high-frequency trading, and the regulatory outlook is analyzed from the standpoint of the current market structure crisis.

Regulating Merchants Of Liquidity: Market Making From Crowded Floors To High-Frequency Trading – Introduction

The market for liquidity, as any other market, is governed by the forces of supply and demand, and the business of providing liquidity by specialized entities known as market makers occupies a unique niche in the securities industry. While market makers may also be crossing their own clients’ orders or participating in order-matching / auctioneering / price-setting mechanisms on trading venues, the essence of market making is to provide liquidity by committing capital. As keenly observed back in 1877 in connection with jobbers operating on the London Stock Exchange (“LSE”), the distinguishing feature of a market maker is being “pretty well always even.” However, the timeframe for this balancing process and the needed capital commitment may vary greatly, depending on a host of factors, such as the underlying business strategy, natural liquidity in the security in question, mandatory capital requirements and other regulatory constraints, and technological advances. Interestingly, Myron S. Scholes of the Black-Scholes fame characterized the business of providing liquidity as living off “omega,” as opposed to “alpha” and “beta,” the better known sources of return. The value provided by market makers in return for omega is no trifle. As pointed out many years ago, “Were it not for this intermediary class . . . the public would experience great delay and inconvenience in their sales or purchase of stock.”

Market making is both restrained and enabled by regulation, which encompasses both governmental and private ordering. Such regulation, which often has its own dark side of rent-seeking, anticompetitive behavior, and consistent non-enforcement, may serve a variety of purposes, such as creating fair and orderly markets, protecting different types of market participants, or operating as a valuable signaling / commitment device. The applicable regulatory framework, as the totality of statutes, rules, enforcement actions, and case law, is established by a blend of governmental regulation and self-regulation, with the latter being set by private regulators, such as the Financial Industry Regulatory Authority (“FINRA”), and trading venues themselves, with some of them acting as self-regulatory organizations (“SROs”). Indeed, providing a private regulatory regime for market makers—as a part of the underlying business model—is a dimension of competition among trading venues.

Liquidity providers with special trading obligations and privileges, as creatures of the applicable regulatory regime, are commonly known as “designated market makers” (“DMMs”), and there may be several tiers of DMMs with varying features operating under different names on the same trading venue. Perhaps the most famous example of DMMs is the famed institution of the “specialist” on the New York Stock Exchange (“NYSE”), which dates back to the 19th century, although specialists were recently renamed “designated market makers” and relieved of their agency and priority-yielding obligations with the adoption of the NYSE’s new market model. While the exact timing of the transition of NYSE specialists from mere matching agents / “brokers’ brokers” to regular dealers entrusted with agency responsibilities is not entirely clear, there is little doubt that committed principal trading became a pivotal element of private ordering quite early. As remarked by an industry insider two decades before the passage of the federal securities statutes,

If it be urged that the specialist should not speculate, but should confine himself solely to executing the orders on his books, it may be answered that in such a case he would often be useless, for in many instances the orders on his books are insufficient in volume to establish a close market or anything approaching it. By reason of his speculations a market is created; without them it may not exist.

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