The Death Spiral Of Exchange Liquidity


By Tan T Kiang, Chief Investment Officer, Grasshopper

Tan T Kiang, Grasshopper

It is the responsibility of exchanges to create and maintain an infrastructure that ensures fair, low-cost trading and a competitive environment for diverse liquidity providers.

Few will object to the necessity of liquidity providers to create a healthy and competitive exchange. Most exchanges welcome market makers and end up creating strong and long-lasting symbiotic relationships with them. Nevertheless, providing liquidity has now become challenging in an environment of rising costs of trading.

Since early 2017, many conversations with different exchanges revolved around the dismaying fact that the number and breadth of liquidity providers in the marketplace has been steadily shrinking.
As the financial industry evolves, market making firms have to keep on adapting and innovating to fight for their market share. Firms which do not invest prudently in technology will end up being outdated or outmoded and eventually die.

The opposite is also true. Firms that spend unwisely or are too broad will suffer the same fate by collapsing under their monthly tech burn rate. The same goes for liquidity providers which did not upgrade themselves as the environment grew more competitive and, they eventually disappeared.

The microwave advantage
Among the market makers still around, one of the most controversial issues was the advent of the microwaves towers. Firms that adopted microwaves significantly reduced their latency, hence increased their edge over their competitors. But in doing so, they also dramatically increased their cost of trading.

In a high-volatility and high-opportunity environment, it may be a no-brainer to all players. But with the current sporadic volatility and short follow-through volumes, this is a dilemma with significant risk. How much more profit do you have to generate to pay the telco companies providing the microwaves towers, before you drown in your trading costs?
Many chose not to enter the microwave game, and decided to change their strategy and invest smarter instead.

Barriers to entry in the market making industry were much lower 25 years ago. Back then, all one needed in the pit was a trader’s jacket and a clerk. The environment was ripe for entrepreneurs to take the first step, and the market was accommodating enough to allow time for trial-and-error or for pivoting to their next successful move.

This was largely the healthy period of high-frequency trading where opportunity and competition gravitated towards an efficient and healthy marketplace. While this took significant capex, risk-taking and dedication, the rewards could justify the paradigm with relationship between market makers (liquidity providers and arbitrageurs), market takers (hedgers and speculators), and exchanges as largely symbiotic. Within each respective category, there were many players from short-term to long-term, arbitrageurs and quants, hedgers and speculators, and primary and secondary marketplaces.

The perils of homogeneity
However, those halcyon days of almost self-fulfilling liquidity and opportunity are now very distant. The decline in the number of liquidity providers is not only an issue in terms of category of player, it also reflects a wider picture of poor health in the whole environment.

Let’s use a grocery store analogy here. Before supermarkets, we had marketplaces filled with specialized stalls. Each merchant specialized in what they did and served the market well because their specialization enabled them to provide a unique and constantly optimised service to the marketplace.
Rather than being able to ask specialized merchants for their suggestions of the season, the pursuit of efficiency has forced the market to serve pre-packaged meat on styrofoam plates in one-stop-shop supermarkets.

So, when there are shocks in the marketplace, all the volume in the market disappears at once. Homogeneity makes markets thinner and price movements more violent, essentially making price discovery much less transparent or easy.

Over the past two years, we have witnessed an accelerated consolidation among liquidity providing firms. With increasing costs of trading, many firms have not been able to scale up fast enough to recover their operational expenses, and ended up being bought out by larger operators who benefited from economies of scale. Meanwhile, exchanges, having never before needed to stem the technological arms race of their participants, have scant idea how to react to the destruction of their participant diversity.
What if the volatility in the market never picks up? Investors won’t want to trade if there is no liquidity, but unless volatility and volume is maintained at a certain level of opportunity, market makers cannot offer liquidity and cover their costs. This becomes a death spiral of negative reinforcement. The systemic health of exchange products are controlled by far too few with far too much concentration risk.

Assuming that the market makers have done all they can on their end to keep afloat, we need to focus on the other side of the equation, which means turning to the exchanges, for a structural overhaul of the marketplace.

Exchanges can provide the remedies
In order to ensure fairness, exchanges have already been active in implementing some changes which prevented trading on the marketplace to become a “pay-to-win” game.
For instance, exchanges introduced colocation to market participants, to neutralize the land grab game.
By placing all the servers in the same location and ensuring that the wire length from the server to the matching engine is exactly the same for all market participants, colocation killed the need for players to buy the properties adjacent to the exchange in order to shorten their wires and hence reduce their time-to-market.

This was a first major step in the defence of a fair marketplace.
Unfortunately, it did not stop the race to zero latency among trading participants. As arbitrage opportunities among highly correlated products are time-sensitive, the search for the fastest access to data has continued and brought on the era of microwaves. This has increased the cost of competing to a highly unsustainable point for many liquidity providers.

Acknowledging the issue, Singapore Exchange has disallowed the use of microwaves on their sovereign territory, but until all other exchanges do so, the problem will remain. Instead of prohibiting microwaves, the exchanges should, as they did with colocation and land-grab, make their use irrelevant. In order to do so, the solution is two-fold.

First, it would require exchanges to bring the market data to a single local colocation point in each country, therefore nullifying the distance between each market participant and the data.
Second, exchanges need to implement speed bumps that would delay all access other than their own, to colocation.

The cost of implementing such infrastructure is minimal compared to the aggregated amount spent by all participants on microwave technology, and it could be shared among all market players. It is the responsibility of the exchanges to keep the marketplace fair with low cost trading and create an environment in which liquidity providers can keep it healthy.

It is high time that exchanges — individually and collectively — tackle this infrastructure overhaul. Not only for liquidity providers’ survival, but for their own.