The CFTC released to the public an authorized research paper titled, “Electronic Market Makers, Trader Anonymity and Market Fragility.” The paper, which was written by third-party professors, analyzes the impact of electronic market-makers on the reliability and the consistency with which financial markets provide transactional liquidity services, based on monitoring intraday position-level data from the WTI Crude Oil futures markets collected from NYMEX between 2006 and 2011.
Researchers found “strong evidence that electronic market makers reduce their participation and their liquidity provision in periods of significantly high and persistent volatility, in periods of significantly high and persistent customer order imbalances, and in periods of significantly high and persistent bid ask spreads.”
Lofchie Comment: The study assumes the inevitability that trading by so-called “locals” will disappear or become irrelevant. Put differently, the study does not call for a doomed-to-fail requirement that the markets reverse themselves and go manual. As to its “praise” of locals for staying in markets during volatile times, the study did not provide any understandable information as to whether the locals were able to trade profitably during periods of market volatility, and, if so, how.
While the study questions whether electronic market makers should be subject to mandatory market-making obligations, it does not suggest that market makers receive any reciprocal benefit. It is unlikely that firms would be willing to become subject to extensive burdens of forced market-making in the absence of receiving a benefit. In fact, one of the defining characteristics of the old NYSE specialist system was that specialists received such a benefit. While there seems to be considerable nostalgia for the willingness of the specialists to limit market volatility, they were generally well rewarded for their willingness and typically earned returns that were viewed as disproportionately high relative to their investment and risk.