Know Your Exchange [Part 1]
Despite some peaks and troughs in popularity, few will object to the necessity of liquidity providers to create a healthy and competitive exchange. Most exchanges welcome market markers 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 of my conversations with different exchanges revolved around the dismaying fact that the number and breadth of liquidity providers on the marketplace has been steadily shrinking.
Like any industries, the firms obey to the rule of the survival of the fittest. As the financial industry evolves, the market making firms have to keep on adapting and innovating to fight for their market share. Firms who do not invest prudently in technology will end up being outdated or outmoded and eventually die. The opposite is also true that firms that spend unwisely or are too broad will suffer the same fate by collapsing under their monthly tech burn rate. Same goes for the liquidity providers, which did not upgrade themselves as the environment grew more competitive and eventually disappeared.
Amongst the market makers still alive, one of most controversial issues was the advent of the microwaves towers. Firms who adopted Microwave significantly reduced their latency, hence increased their edge over their competitors, but in doing so, 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 the telco companies providing the microwaves towers, before you drown in your trading costs?
Many, like Grasshopper, chose not to enter the microwave game, and decided to change their strategy and invest smarter instead.
When our Founder-CEO John Lin started Grasshopper in 2006, the barriers to entry in the market making industry were much lower. After all, when he first started trading, all he needed in the pit was a trader’s jacket and a clerk. The environment was ripe for entrepreneurs to take the the first step, and the market was accommodating enough to allow time for trial and error or pivoting to their next successful move. This was largely the healthy period of high-frequency trading where opportunity and competition gravitated towards an efficient but healthy marketplace. While this took significant capex, risk-taking and dedication, the rewards could justify the paradigm between market makers (liquidity providers and arbitrageurs), market takers (hedgers and speculators), and exchanges as largely symbiotic. Within each respective category were many players from short term to long term, arbitrageurs vs. quants, hedgers vs. speculators, and primary vs. secondary marketplaces.
For us, it turned out to be John’s decision to move into the electronic market making space. Since then, the competition has grown cut-throat and we constantly have had to innovate to have skin in the game, let alone survive. All of the innovations that we have accomplished, whether they come as faster computers or building software internally, have come at a huge capital investment and recurring monthly costs.
As a liquidity provider and designated market maker, I constantly think about what makes an exchange great for investors. My opinion is that volume begets volume, and the greater the liquidity, the more investors any exchange will attract.
However, those halcyon days of almost self-fulfilling liquidity and opportunity are now very distant. The decline in the number of liquidity providers not only an issue in terms that category of player, it also (like most ecosystems) 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 do and served the market well because their specialization enables them to provide a unique and constantly optimised service to the marketplace. One would be able to go to a butcher and ask their opinion on what cut of meat would be most appropriate for the dish you are preparing. In the pursuit for efficiency in the marketplace, we lost the diversity in specialized liquidity providers. Rather than being able to ask specialized merchants for their suggestions of the season, 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 is disappearing at once. Homogeneity makes markets thinner and price movements violent, essentially making price discovery much less transparent or easy.
Over the past two years, we have witnessed an accelerated consolidation amongst the 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, has scant idea how to react to the decimation of their participant diversity.
What if the volatility on the market never picks up? Investors won’t want to trade if there is no liquidity of a product, 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.
Of course, no one expects sympathy from the masses about declining market making profitability; but that is a real and profound service for any capitalist based society. While all would generally applaud lower costs for the end user, we are past the sweet spot and as the market place is now, when market shocks happen these days, 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 could 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.
So what’s next? In Part II, I will be discussing the solutions that I propose to the exchanges to fix reduce the imbalances in the marketplace.
