From the October 01, 2006 issue of Futures Magazine • Subscribe!

The liquidity mirage

LIQUIDITY LIMITS

The electronic market does not have a market maker facility per se. Every short-term trader on the electronic side is, broadly speaking, reacting to price rather than creating the market. These “flippers for a penny” do not have any concept of the infrastructure that is necessary to allow them to continue flipping at ever faster rates of speed, creating unprecedented intraday volatility. The market-maker infrastructure — historically composed of the locals — is aimed at maintaining an orderly market with a bid and ask price at minimum quantity on a continual basis to all comers under whatever time of day or circumstances. In other words, they are the guarantors of liquidity. The advent of 23.5-hour electronic markets means that at times the bid/ask spread is wide on minimal

volume, creating a lack of liquidity or even a lack of transparency. Therefore, a single order can have an exaggerated effect on price.

“Take my order — please,” is an example of a liquidity mirage. On July 21, the GBP/USD cash market was moving up in the London session and breaking above the Asian session in bracket “l” and “m” in the Market Profile chart. The high in the “q”

period was 1.8561. Compare this to the electronic futures contract for the September British pound futures; note, the spike in the “q” period, where stops were filled at about 30 ticks premium to the underlying cash market, after taking into account the swap differential for the spot vs. the futures.

“Trouble in Tokyo” demonstrates a similar problem in the JPY/USD market. Note the green bar circled in yellow for July 5. Now see the smash-down equivalent in the Japanese yen futures market in the accompanying 30-minute chart. This was the equivalent of 250 ticks above the cash in the USD/JPY.

“Unsupported surge” shows the same September Japanese yen contract (the futures is charted in reciprocal mode for a direct comparison of the futures and spot market), along with the cash market. The next 10 days of trading shows how the market retested the extent of the liquidity mirage unfair trade on both the cash and futures sides.

SHOCK AND AWE

Another form of liquidity mirage occurs just as a government report is released or a major speech is made. Order flow bandwidth, simply meaning a market’s capacity to handle a sudden influx of large orders, is far too small for the growing level of transactions and the many varied products, some of which are just replications of each other.

When bandwidth capacity is reached, which happens all too frequently, the result for the trader may initially be a frozen screen. It may be frozen or blank or prices may even appear to be backward — that is, the bid is above the ask. Indeed, the screen may show moving prices but they are so far behind the real action that when the trader tries to transact, his order appears in limbo or sits unfilled or in wait status.

The natural reaction of any reasonable trader is clear: They phone their broker. This reveals the second level of the liquidity mirage. Most online brokers are not geared, in terms of technology or flesh-and-blood staff, to receive a huge number of potentially panicked but more likely frustrated traders all screaming to know whether they have a position. The broker is not able to tell them for several reasons.

First, they may not wish to make a committed statement in case it turns out to be incorrect, making themselves and their employer financially liable. It may also be that the broker is in exactly the same position as the customer, relying on the same data feed or software, and that they cannot tell due to the same bandwidth capacity problem affecting all their customers. When the broker tries to phone the exchange, the market control center can only handle one situation at a time due to the same constraints affecting the broker.

Whatever the cause of the delay, markets don’t wait for handcuffed, would-be participants. They never have, and don’t be fooled into thinking they ever will. By this time, prices have moved several percent and many customers are effectively locked out from either taking advantage or just mitigating exposure risk.

The opportunity loss is incalculable. Forget the poor, single market retail trader. Consider a normal large hedge fund where on the release of the government report, the manager wished to dump stocks in three European markets and two U.S. stock indexes at the same time, buying some bond futures and trading several hundred million in currencies.

As the world moves toward fully electronic trading, those responsible, whether regulatory authorities or the exchanges, pay little heed to the financial risks this entails, leaving many in a situation where they must sell the good to pay for the bad just to remain within margin constraints. This is where systemic risk is at its greatest. The continued move toward automated trading aggravates order flow bandwidth and rather than improving the liquidity factor it diminishes it, leaving orders fired off that risk managers cannot see and have little control over.

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