stock exchanges « Citizen Economists

Paying for liquidity provision on exchanges

By Ajay Shah, on September 19th, 2011

Market making versus the electronic limit order book

Exchanges in India all operate as electronic limit order book markets. There are no `market makers’; there is just a publicly visible limit order book. Anyone is free to supply liquidity, by placing limit orders. The person who places market orders is the consumer of liquidity: he pays market impact cost. [A guide to the jargon].

Prior to the rise of the anonymous limit order book, there used to be a great deal of effort on thinking about the market maker. Market makers played a big role in many old markets. E.g. at the NYSE, the `specialist’ was obliged to provide liquidity. RBI established `primary dealers’ thinking that they would provide liquidity.

These market structures involved complicated problems of measuring the liquidity provision by market makers, correctly compensating them, avoiding monopoly power in the hands of the market market, and enforcing against market manipulation by the market maker. The rise of the open electronic order book cut through this Gordian knot.

For many years, there used to be a debate about whether the anonymous open limit order book market (where anyone can provide liquidity) is better or worse than a market maker market (where limit orders can only be placed by one or more market makers). That debate died down in the 1990s with the success of the electronic limit order book. Market making on the electronic limit order book

But even on a limit order book, does it make sense to pay one or more market makers to provide liquidity? The public would be free to place limit orders, but one or more market makers would be paid to place limit orders.

The positive argument runs like this. In the life of every contract, at first there is a lack of liquidity as various market participants are reluctant to take the plunge and trade on an illiquid contract. This leads to a chicken and egg problem. Illiquidity inhibits participation, and the lack of participation is illiquidity.

From a regulatory perspectives, exchanges might try to make payments for liquidity provision (or outright turnover) by various underhand means. If that is going to happen, then it is better to have this come out into the open.

But there are also important problems that can come out by going down this route. The resources that an exchange puts into portraying tight spreads or high turnover could potentially be used to improve services for customers. Market participants would make wrong decisions about an investment decision when they see a product as looking liquid on screen, whereas this liquidity is actually artificial: the screen would be falsely portraying liquidity. When exchanges compete on payments to market makers, this can degenerate into a slugfest where the deepest pockets win.

The artificial liquidity pushed by mercenary market makers would tend to lull the exchange into complacence. In the absence of market making, the exchange would run harder to solve problems of market mechanisms and contract design, and to get the word out about the contract.

Recent developments in India

On 2 June 2011, SEBI chose to move ahead with the specification of a `Liquidity Enhancement Scheme’ (LES).

By these rules, LES is applicable for individual stocks where the trading volume on the last 60 days is below 0.1 per cent of the market capitalisation. (How would this be scaled to derivatives such as currency futures, where market capitalisation cannot be defined?) I think this makes sense. The LES would be used to kickstart liquidity when it is abysmal. The moment a small amount of liquidity comes about, the LES would step aside.

Based on these rules, NSE announced a program for market making on the derivatives products recently launched at the exchange: on the S&P 500 and the Dow Jones Industrial Average (launched in partnership with the Chicago Mercantile Exchange). These incentives are over and above the absence of charges by the exchange. I was disappointed to see a payment based on mere turnover. This would give the market maker an incentive to do circular trading and thus show a lot of trades. But turnover is not liquidity.

This program came into effect on 15 September. It may matter more in the coming week, given that new contract series start trading from tomorrow. Will it matter? How will we know that it mattered?

Derivatives on the S&P 500 and the Dow Jones indexes have gotten off to a surprisingly good start, even though there was no such program. This has perhaps been helped by unusual levels of volatility in the US after the launch of these contracts.

The early days of a contract can be a rollicking ride and even after these time-series fall into place, it will not be easy to tell whether LES was useful in the history of these contracts or not.

Similar thinking is taking place at BSE also: See Will BSE’s biggest initiative work? by Mobis Philipose in Mint. The text there — obligations such as providing two-way continuous quotes within specified parameters for quote size and spread — sounds good, but here also there are payments per crore of turnover. By and large, the payments being made at BSE look much bigger than those at NSE.

In the case of BSE, if LES is able to lift BSE out of zero market share in derivatives trading, even after the six month period has expired, then it would be a clear proof that the LES helped. So this experiment is unlike that of NSE where it will be hard to evaluate whether or not the LES mattered.

Alternative Stock Market Indexes

By Ajay Shah, on December 6th, 2010

I saw this interesting article about the mind-share of Nifty as opposed to the BSE Sensex. It is by Samie Modak and Muthukumar K. in
the Financial Express.

The NSE data for June 2010 shows that Nifty futures have peaked at Rs.0.36 trillion of notional turnover in a day (27 Jan 2010) and
Nifty options have peaked at Rs.0.89 trillion of notional turnover in a day (24 June 2010). Nifty has shaped up as one of the big
contracts by world standards. It is interesting to go back and read the original paper. Those were interesting times. Looking back, it
seems obvious that Nifty would dominate the derivatives market, but at the time, the outcome was far from clear.

This made me look at data on risk and reward of the alternative indexes. I start from the first data for Nifty Junior, which takes me back to 21 February 1997, thus giving data for 13.7 years.

	Mean	Volatility	Ratio
Nifty	12.99	26.37	0.4926
BSE Sensex	12.68	26.92	0.4711
Nifty Jr.	18.16	32.38	0.5608
CMIE Cospi	17.40	27.23	0.6391

Nifty and the BSE Sensex are a lot like each other.

The real surprise is Nifty Junior: Merely moving down from rank 1-50 to ranks 51-100 has given an enormous juice in the return and in the reward-to-risk ratio. But the volatility of Nifty Junior is also higher.

The CMIE Cospi index has roughly 2800 stocks today, and represents the broad market. It includes the Nifty Junior stocks and a host of other smaller stocks. But unfortunately, these numbers are not comprabale with the other three in that it includes dividends while the other three do not. With this combination of high diversification (giving a low volatility), small-cap stocks (which helps returns) and inclusion of dividends (which helps returns), it is not surprising that it scores the best reward-to-risk ratio.

In my mind, most of the claims of out-performance by active managers in India are purely about being invested in the non-Nifty
space. Nifty Junior ETFs are easily accessible and I get surprised that more people aren’t putting this into their investment strategy.

A Cross-Country Comparison of Charges of Exchanges

By Ajay Shah, on October 26th, 2010

In reading this article in the Wall Street Journal by By Rebecca Thurlow, Alison Tudor And P. R. Venkat about the potential merger of SGX with ASX, I saw this interesting cross-country comparison of exchange charges (in basis points):

Country	Trading and clearing	Taxes
Singapore	4.75	0
Hong Kong	1.1	20
Taiwan	0.75	30
Korea	0.54	30
Australia	0.53	0
India	0.35	27
Japan	0.24	0

It is quite a striking set of facts.

First, we see that in terms of the core trading and clearing — the charges of the exchange — India is the 2nd lowest in this pile, with a value of 0.35 basis points. This is slightly worse than Japan (0.24 basis points) and superior to all the others. This partly derives from the immense economies of scale at NSE and BSE, which are ranked at 3 and 5 in the world by number of transactions. This is also about the cost-efficiency of the human part of running an exchange: small exchanges like SGX cannot match the price points which NSE and BSE can reach. In this field, as in finance more broadly, India is pretty good at reaching up to world class at below the world price. This was the basic logic, if you recall, of Percy Mistry’s Mumbai as an International Financial Centre report.

Secondly, we see the huge problem that transactions taxes present in all these countries other than Singapore, Australia and Japan. The Indian charge of 0.35 basis points is just swamped by the taxation of 27 basis points. Even if NSE cut charges by half, and got down to 0.175 basis points, this would do nothing for the end-customer who is paying 27.35 today and ends up paying 27.175 across the price cut. Conversely, Singapore, with the least efficient exchange (4.75 basis points) ends up being a nice place for the customer because there is no tax upon transactions there: only Australia and Japan are better than Singapore.

Economists are very clear that all taxation of transactions is distortionary. It’s puzzling why so many countries (four out of these seven) continue to indulge in something which is an elementary mistake in public policy.

The Trading Hours Controversy

By Ajay Shah, on December 24th, 2009

Shifting away from central planning

Traditionally, Indian socialism has involved government control of all aspects of financial products or processes. As an example, government specified the time of day at which trading starts and the time of day where it stops. The RBI committee process on currency futures and interest rate futures specified that trading must start at 9 AM and stop at 5 PM.

In most areas of the Indian economy, goverment no longer controls the economy in such fashion. The government does not specify what time a shop opens or closes. There was a time when the Indian government did not permit the use of aluminium for making cans of soft drinks. A large fraction of such meddling in the economy has been dismantled (though not in finance).

A few weeks ago, SEBI came out with a liberalised policy: Exchanges could open anytime afer 9 AM and stop trading anytime before 5 PM. If NSE or BSE opt for longer hours, securities firms will face the decision about the time at which the shop opens for business and the time at which it closes. Staying open longer will involve somewhat higher costs and in return will yield somewhat higher revenues. Each shop will make its own decision about choosing a starting and a closing time.

What do we gain?

If Indian markets to be open from 9 AM to 9 PM, there are two benefits. First, consumers should have maximal choice on when they can achieve their trading needs. Recall that internationally, many grocery stores choose to stay open for 24 hours a day.

Second, in the late evening in India, the ADR market opens in the US, and it is important to link up the closing Indian prices to the opening US prices.

How will exchanges and their members cope?

If securities firms have to stay open for 12 hours a day, this will require process modification, including multiple shifts for certain employees.

These changes might seem burdensome. But similar changes have taken place before. With floor trading at the BSE, trading only lasted for two hours a day; but when NSE came along, trading moved up to 5.5 hours a day. Members doing commodity trading are already running to almost midnight.

Securities firms and exchanges will need to change their process design to achieve longer hours. If a securities firm has to trade from 9 to 9, this will require two shifts. The first shift will probably come to work at 8 AM, and stay till 3 PM, while a second shift will probably come to work at 3 PM and stay till 10 PM. Some firms will find that this does not make sense for them and they will choose to only keep their shop open for shorter hours.

The operation of securities markets in India is held back by infirmities of the payment system. A shift to longer trading hours will encounter frictions owing to problems with payments.

At first, clumsy solutions will be found because of problems of the payments system. But at the same time, when the industry demands more from the payments system, we set ourselves on the course for deeper surgery of the payments system. In this 21st century, we can and should have a payments system which processes 100,000 messages per second and runs for 24 hours a day. When the industry complains enough about the infirmities of what is in place, the existing payments system will be questioned, which could ultimately lead to improvements in the payments infrastructure.

A messy situation?

NSE and BSE have gone through a series of announcements. First, BSE said they would start at 9:45. Then NSE said they would start at 9 AM. Then both said they would think about this after the holidays.

These activities seem messy and confusing in the public eye. These tactical details are an inherent part of the market economy. When government control is withdrawn, and a license-permit raj is scaled down, we go from a tranquil and stable environment — the silence of a graveyard — to a dynamic environment where firms are thinking and reacting. This should be welcome.

Doing more on moving away from central planning

SEBI needs to move forward on many fronts in terms of getting away from government control of product features. There is no reason to restrict exchanges to the zone from 9 to 5. Similarly, many other product features on the derivatives market need to be decontrolled: what underlyings to use, whether cash settlement or physical settlement, the expiry dates, the contract sizes, etc. Government control of these product features is as legitimate as government control over the design of a bicycle.

There is a difference between regulation and control. The role of government is to specify pollution standards for cars and to require seat belts or airbags. It is not to design cars.

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The Coming Market Crash

By Trace Mayer, on July 28th, 2009

“By the pricking of my thumbs, / Something wicked this way comes” is from Act 4, scene 1, lines 40-41 of the Bard’s Macbeth.

A year ago at Cambridge House when asked whether the economy was going to rebound I responded, “That light at the end of the tunnel is just the next train. Get out of the way!” Another commentator on stage responded that things would get better. What happened?

Lehman Brothers, AIG, Fannie Mae, Freddie Mac, Bank of America, Merrill Lynch, Citigroup, the Adjusted Monetary Base exploded from $800B to $1,800B as the Federal Reserve fails with quantitate easing, unemployment began to soar and the DOW crashed from 12,000 to 6,500 or 13.95 gold ounces to 7.

The prehistoric media wails about how no-one saw this crisis coming. Yet they are still praising Obama’s economic policies, heralding an economic recovery and living in denial. Why believe them? Why even read their newspapers or turn to their channels? Many people, coincidentally almost all of the Austrian school of economics, saw this financial and economic crisis coming.

There is another massive crash coming. For those people who do not see this coming crash the issue is not one of subjective or objective opinions. The issue is a personality block where the individual cannot handle the truth. If you see neither were we are nor where we are headed then you have a personality block and need professional therapy.

ASSET LIQUIDITY

Price is what you pay but value is what you get. During the Great Credit Contraction capital is seeking not only the safest assets but also the most liquid.

Market liquidity is a business, economics or investment term that refers to an asset’s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.

Famed value investor Warren Buffett managed to see his net worth fluctuate from $62B to $37B over the past year. His paper profit from bailing out Goldman Sachs has already earned about $2B. Despite his ‘massive losses’ there is a lot to learn from Buffett’s annual letter to shareholders. I have read them all. Particularly interesting is his view on market liquidity from 1993:

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?

NYSE Program Trading (Click here for full size)

At the end of the day, a buyer and a seller agree on a price. Prices in the public markets are always set at the margins. When the transaction is not consensual, such as with robbery, there is no price and such transactions are unsustainable because they are immoral and will eventually always fail.

The quoted price for assets is becoming increasingly illusory because of the fake liquidity which will learn how to vanish. For example, the NYSE reported, “Due to an NYSE system error, Goldman, Sachs & Co. was inadvertently omitted from the chart of most active firms, but the firm’s program activity was included in the total level of programs as a percentage of NYSE volume, which remains unchanged at 48.6 percent.”

Naked short sales or FTDs (failure-to-deliver) that represent about 37.5% of the volume of securities that require delivery. The galavanting SEC has now taking steps against but it is probably a too little too late. Many investors would be flabbergasted to know that the 100 shares of YYY in their brokerage account were really failure-to-deliver IOUs for 100 shares of YYY. Combined with the fake liquidity that can be instantly withdrawn if serious selling starts it will create a very unfavorable marketplace for additional potential sellers.

ASSET VALUATIONS

There are many ways to value assets such as ownership of a company, real estate, etc. Some of the basics include discounted future cash flows, dividend payout ratio, price to earnings multiple, book value, etc. When assessing the health of a company I get a quick snapshot from the current ratio, acid test ratio, return on equity, free cash flow, net income and dividend payout ratio. I like dividends because when cash must be distributed it is much more difficult for management to play accounting games using the new generally accepted fair value lying standards.

The payout ratio is the percentage of earnings paid to investors and is calculated by dividing yearly dividends per share by the price per share and is the opposite of the plowback ratio. Think of cash like blood and dividends like blood donations. Extremely healthy companies can donate lots of blood without hindering their operations and the investor can then deploy the cash elsewhere for a higher return.

The S&P 500 is a value weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. Dividends are an important component of the total return from equities, accounting for a third of the total return of S&P 500 since 1926.

The S&P 500 earnings have collapsed while dividends have declined at a slower rate. As Ian McAvity has demonstrated, the dividend to earning ratio is now above 300%. This means companies are distributing $3 of dividends for every $1 of earnings. This is accomplished by burning through cash reserves, selling off assets, borrowing, etc. This is unsustainable.

One would think that only the New York Times is stupid enough to borrow money to pay dividends while gross revenue and net income decline. Likewise the current price to earnings ratio of the S&P 500 needs a reality check. When body mass is shrinking (declining gross revenue), blood is leaking (lower earnings or losses) the last thing those setting dividend policy should do is pull out another knife and cut themselves deeper to hemorrhage faster.

But perhaps they are listening to the propaganda organs that neither saw the gathering economic storms nor have taken shelter from the browbeating winds and think their earnings are going to recover which will bring the ratios back into normalcy.

UNEMPLOYMENT

This is no ordinary recession. Obama is intentionally exacerbating the greater depression. For the appetizer the American economy has lost over 4 million jobs. 30 June 2008 the Emergency Unemployment Compensation program began. Benefits have been extended twice. Obama may delay the first course of dinner by extending it a third time. The National Employment Law project estimates that, “Around the country, the number of people exhausting their benefits is piling up. By the end of September, more than 500,000 people will exhaust their benefits checks”.

The Great Depression lasted for over two decades and was not a single event. The early years were marked by lost jobs which were not replaced. As top lines evaporated they were not replaced. People and businesses began to deplete their savings before becoming destitute and getting corralled into soup lines.

In the present case, job losses have been piling up like a massive train wreck. The American consumer has slightly scaled back on their purchases because they still have access to liquidity such as unemployment benefits, credit cards, 401Ks (which have become 201Ks), etc. Those sources of liquidity are drying up as credit card limits are slashed, minimum payments are raised, HELOCs are denied, retirement plans collapse and now, in September, unemployment benefits will end.

The numbers on that chart are estimated to go from 50,000 to 1,500,000 by the end of the year or a 3,000% increase. The issue for the American families kicked out of their worthless homes and onto the street is becoming survivalism in the suburbs. People are not going to care about contributing to their retirement plans, buying name brands like Coca Cola, Proctor & Gamble, Wonderbread, etc. They are going to care about generic bread or Top Ramen on the table.

Consequently, gross revenues for the S&P 500, which are down 10% year over year, are going to be under even more pressure. With most of the slack already trimmed earnings are going to be under even greater pressure. To bring PE ratios into historical norms stock prices are going to have to tumble.

COMMERCIAL REAL ESTATE

The value of real estate is a function of the earning capacity of the underlying business base. With collapsing earnings, rapidly rising unemployment and a commercial real estate market ice age the value of commercial real estate is plummeting. Originations of commercial mortgage backed securities is almost non-existent. Financing for new purchases is almost impossible to secure. Being able to find comparables for appraisals is getting increasingly difficult. Real property taxes will likewise decline putting further strain on state budgets which are in chaos like California.

Many outstanding loans are non-performing and the lending banks are failing. From the 6th to the 27th of July another 12 banks have failed. In January 2008 I warned that the FDIC was preparing for massive bank failures. Lately I have warned about how the annual worldwide platinum production is valued at about $7.8B compared to the FDIC’s $12B of reserves to cover$4,831B of insured deposits. The monetary metals are one way to protect yourself from the risk of massive bank failures and a potential bank holiday.

MARKET MANIPULATIONS

Chris Powell of the Gold Anti-Trust Action Committee has observed that “There are no markets anymore, just interventions.” Where would the manipulators get the massive amounts of capital needed? Perhaps Donald Rumsfeld knows.

The United States Constitution provided safeguards against these types of problems. This is one reason the barbarous relic known as the Federal Reserve should be razed. The unfair and immoral monetary system is complete opposition to a Constitutional monetary system. These interventions of manipulating both the supply and cost of currency are failing as is the Federal Reserve’s attempt at quantitative easing.

MONETARY METALS

During The Great Credit Contraction capital will seek the safest and most liquid assets. At all times and in all circumstances gold remains money. Because of the large aboveground stockpiles gold is the world’s primary monetary commodity. Likewise silver and platinum are also risk-free commodity currencies.

Two weeks ago I recommending buying platinum which has since risen $80 per ounce or about 9%. I also recently suggested buying silver around FRN$12.50 which is now over $14 or about a 12% gain.

I have found GoldMoney to be the best alternative to the current failing worldwide monetary system. I recently sold a few copies of The Great Credit Contraction for platinum. A Swedish buyer remarked, “I have now made my first payment in platinum … I think we may have seen a glimpse of the future. … (And as a gold-bug I think it can be good.) Thanks a Lot!”

Many people may take for granted the liquidity of the financial markets, banking system and other grease for the wheels of commerce. How would your investments be affected if the financial markets closed for 1-2 years? How would your business be impacted if there was a bank holiday for an undetermined period of time?

Having an alternative system, completely independent on the current failing structure, in place and operational is good business sense. Eventually the Information Age alternative to the barbarous relics of central banks and fractional reserve banking become complete substitutes because of the lower costs, ease of use, lower risk and other superior attributes. As the liquidity of the monetary metals increases through their use in ordinary daily transactions, like being used to purchase books, their value will rise.

Additionally, gold’s technicals are looking extremely strong. The 200dma at $880 while the current price is about $955 or 1.08x. The 18 month consolidation above $900 has laid a very strong foundation for the next upleg. The reverse head and shoulders pattern is extremly bullish. Seasonally gold is weak during the summer and strong during the fall but lately it has been trading like power currency.

While massive short positions are being taken by commercials gold will likely easily breach and maintain $1,000 ounce this fall. With unemployment skyrocketing, bailout fever in Washington, earnings declining the FRN$ is going to be under tremendous pressure from ballooning budget deficits which will have to be monetized. All of this is positive for the ancient metal of kings.

CONCLUSION

The Great Credit Contraction, an economic climate change from an inflationary summer to a deflationary ice age, has barely begun. The remaining liquidity in the market is largely illusory. Residential real estate, commercial real estate, the major stock markets and even the banks are almost all zombie institutions anchored to fraudulent financial statements that are preventing the needed healing liquidation. The unemployment situation is escalating out of control and The Greater Depression is wearing on people and psychology is being changed. Earnings are collapsing and dividend to earning payout ratios are unsustainable. Meanwhile the monetary metals appear poised for a significant rise as the FRN$ continues evaporating.

Because there is no intelligible answer for what is a dollar therefore it is an unreliable instrument for performing mental calculations of value. This next crash which appears imminent but could take a while to materialize because of manipulations will likely see the DOW fall from its current 9.5 ounces to about 5 ounces of gold and the S&P 500 sliding from its current 1.3 ounces of gold to about 0.85 ounces.

Additionally, the really good buying opportunities will be enjoyed by those who can settle transactions because their assets are liquid, like with gold coins in a safe or a reputable third-party like GoldMoney, and not frozen in some closed market or holidaying bank. If you want real cash, not illusions like the FRN$, Euro, Yen, Pound, etc. which can evaporate in hyperinflation, then you better learn how to buy gold because it is the safest and most liquid asset. With gold you will always be able to buy something.

Disclosures: Long physical gold, silver and platinum with no positions in the problematic GLD or SLV ETFs, S&P 500, DOW, NYT, GS, Berkshire Hathaway, Coca Cola, Proctor & Gamble, Bank of America or Citigroup.

Copyright © 2008. This article was published on http://www.RunToGold.com by Trace Mayer, J.D. on July 27, 2009. This feed is for personal and non-commercial use only. Applicable legal information and disclosures are available. The use of this feed on other websites may breach copyright. If this content is not in your news reader then it may make the page you are viewing an infringement of the copyright. Please inform us at legal@runtogold.com so we can determine what action, if any, to take. If you are interested in how to buy gold or silver then you may consider GoldMoney.(Digital Fingerprint: 1122aabbLittleBrotherIsWatching3344ccdd)

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Paying for liquidity provision on exchanges

Market making versus the electronic limit order book

Alternative Stock Market Indexes

A Cross-Country Comparison of Charges of Exchanges