Bank for International Settlements Examines Data on Liquidity Supply

The Bank for International Settlements (“BIS”) examined data showing that proprietary traders tend to place marketable buy orders after price drops, and marketable sell orders after price increases. This behavior helps the market absorb liquidity shocks – even during a crisis – and results in profits for the traders. The findings, contained in a working paper, highlight several consequences to recent regulatory reforms.

The BIS determined that while adverse selection costs for non-immediately executed limit orders are lower for fast traders (relying on advanced technology) than they are for slow traders, only proprietary traders can afford to leave limit orders in the book without bearing losses. According to the BIS paper, this finding suggests that technology alone is inadequate to overcome adverse selection costs; proper monitoring incentives are also necessary.

The paper highlighted other consequences:

  • Markets in Financial Instruments Directive (“MiFID II”): The requirement that trading venues cap the ratio of the number of messages with the number of trades given by any participant “might be counterproductive” because fast proprietary traders rely on numerous cancellations and updates to reduce the adverse selection cost incurred by their limit orders. The adverse selection costs incurred by limit orders left in the book could be increased by capping the percentage of cancellations and updates and thus deter the provision of liquidity by these orders.
  • Numerous New Banking Regulations: By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations also might reduce market liquidity.

The paper’s findings are based on the results of unique data from Euronext and the Autorité des Marchés Financiers (French “Financial Markets Regulator”).

Lofchie Comment: “By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations might also reduce market liquidity.” In other words, through their well-intentioned attempts to make banks “safer,” the banking regulators very well may be causing the markets to become far more fragile; i.e., vulnerable to a sudden crash as soon as markets turn in a negative direction because no one will be willing to buy, and consequently banks will become even less “safe.”

The analogy that Craig Pirrong makes of building up a dike in one spot without regard to the strength of the system as a whole is very appropriate. The bank regulators have focused on demonstrating the safety of the central clearing corporations and on the capital levels of banks, but, arguably, they are doing so at the cost of the overall safety of the system as a whole. The very high capital charges imposed on banks are likely to motivate banks to sell off assets very quickly in a market downturn; and the ability of central clearing corporations to demand unlimited collateral from clearing intermediaries will allow them to quickly drain liquidity out of the system when markets become volatile.