August 3, 2010

Your Volume and the Maker-Taker Model

You’ve heard the saying “six of one, half-dozen of the other?”

The DXY, the spot market for the US dollar, declined 7% in July. Stocks were up 7%. May was a good month for the DXY, which rose from 81 to 87, roughly. May crucified equities and gave us the Flash Crash on the heels of a surge in the value of the dollar.

Is it six of one, half a dozen of the other? The dollar in your pocket loses 7% of its purchasing power versus other currencies in July. Stocks appreciate 7%. Call me simple, but it seems that when a thing you buy is worth more because the thing you buy it with is worth less, that these sort of cancel each other out.

Which brings us to making and taking liquidity, the main method by which traded shares move today. In this “maker-taker” model, market centers pay participants to provide shares that attract customers, and charge customers to consume these offered shares. The spread is profit. At BATS Exchange the cost gap between consuming and providing shares is one penny per hundred shares. On the Nasdaq and the NYSE it’s about five or six cents, but narrows if you offer tens of millions of shares daily.

This is crucial to understand. If you conclude that your volume is buying and selling meeting up, that’s true only sometimes. Most of the time, buyers are consuming shares offered by other market participants whose principal job is to keep the liquidity flowing, for pay. This is why high-frequency trading exists, really. Technology and human ingenuity adapted to market structure built around incentives. So now, there are systems doing both the providing and consuming, and if the spread between the two prices is a penny, and your stock moves two pennies, why that’s riskless profit. Mind, that’s harder to do than it seems!

Where do shares come from that liquidity providers offer for sale? Somebody always has inventory. Sometimes it’s coming from major broker-dealers whose millions of retail and institutional account holders don’t realize that their positions are used to generate profits for market-making operations. This is the main reason why Citadel invested in E*Trade. In many other cases, shares simply move from place to place at high speed.

To do that, traders can arbitrage different structures. Most market centers now, like BATS, Nasdaq, Direct Edge, and so on, are “time-priority” models, where the first to show up at the best bid or offer gets to complete the trade. On the NYSE floor, it’s a “parity” model that gets apportioned to all parties priced at market. So if you’re fast enough, you can move shares from parity to time priority and back and forth. This constant replenishment generates revenues for the firms doing it and looks like massive volume. It’s often the same liquidity appearing again in different places.

What’s good about this? It keeps price spreads tight, and it ensures that vast numbers of securities, regardless of appeal, offer anyone wanting to transact in them an easy, ready market. If you’re asset allocation managers, these are great conditions. Think of it like swiping your credit card through a reader rather than needing the exact cash price each time you buy.

What’s bad about it? Number one, market centers are motivated to entice volume that isn’t real. They make money through transactions. More transactions, more data to monetize too. This is not the fault of exchanges. They are businesses producing returns for shareholders. But if parties matching your product with buyers and sellers are financially incented to attract middle men, in time your market is most appealing to intermediaries and least appealing to real buyers and sellers.

That’s what maker-taker models encourage. Transient intermediation. It’s the most reliable way to make money. If 80% of volume is moving from place to place, and you’re in the 20% buying and holding, what form of activity is more likely to produce a return on investment? Clearly, making and taking liquidity, not owning things.

But the biggest problem is the same one afflicting the US dollar. In stock markets now, the maker-taker model has removed the focus of market participants from the value of businesses to the supply or demand of shares. The study, manipulation, and maximization of liquidity movement have come dangerously near to disconnecting underlying business fundamentals from stock markets. Intermediaries trade stuff for spreads. They don’t own investments for their intrinsic value.

This is true of the dollar too. Its value bears no connection to underlying national productivity or assets. That’s the essence of “fiat” currencies, and we’re near now to having “fiat stocks” too. Movement of the dollar from place to place alters the value of all the goods and services denominated by it. In time, no one knows the value of either the goods and services or the currency in which these things are valued. Then, the data derived from transactions in it are incorrect or distorted, too.

Think about this: does the same thing happen in the global economy that we described with the DXY and stocks? What if it’s just yin and yang of currencies and goods and services, with no real change in economic output? That path would lead almost ineluctably to large national debts.

Oh. Hm.

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