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I believe that liquidity, deep liquidity is the mother's milk of futures markets. Liquidity is what built our Exchange and our franchise. Liquidity is our past, present and future. What does liquidity mean to our markets? What is the future of liquidity? Does liquidity mean the same to everyone involved in our markets? What are the consequences if all involved do not define liquidity similarly?
I believe liquidity is "an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. A market with deep liquidity is characterized by the presence of willing buyers and sellers in an on-going competitive environment. This market will have a high probability of facilitating the next trade at a price close to or the same as the last price. (1) … Encyclopedia Britannica, Barrons, Wikopedia, R.T. Manaster.
This definition is precise. It is simple to understand. It was the industry standard. Our markets provided the deep liquidity this definition describes. Unfortunately now, due to the precipitous decline of open outcry, and with the advent of sophisticated electronic methods designed specifically to game the exchange algorithms…at crucial times there is no deep liquidity!
The "flash crash" of May 6, 2010 is the quintessential example of liquidity vanished.
Therefore we should be sensitive to the needs of market makers as part of our business model, instead of using them as bait for predatory market takers. If we do so, our futures markets can provide this deep liquidity again.
The markets seem to tell a different story of liquidity now .The management of both the CME, the CFTC and for that matter the country's stock exchanges have a dramatically different view of how liquidity should be defined.
Their definition, their idea of liquidity is a 'snapshot' glimpse of an arbitrary time window displaying a large bid below and close to the last price and a similarly large offer close to and above the last price. To market makers such as my firm, the 'snapshot' is missing key elements. We feel that liquidity as understood by the CME and the Commission is correct in most market situations. Sadly, as explained in the next paragraph, their definition has resulted in creating a construct that is not sufficient to preserve the deep robust liquidity that made our trading floors the envy of the economic world.
Our markets have suffered because the CME order allocation algorithm is based on assumptions from the 'snapshot definition." This algorithm initially encouraged volume until High Frequency Traders- (market takers) began to game the algorithm, sucking up liquidity. With spreads widening, volume has decreased over 10 % this year.
The definition we propose contains two theoretical trades. If the exchange does not concern itself with the second trade, which should allow market makers reasonable expectation to secure a price at, or near the price of the first trade, liquidity will decrease and the business model we have built over the last 150 years will be destroyed. Avoiding these dire consequences- liquidity debasement and the ultimate destruction of the franchise- must be our primary focus.
Recently, Mr. Jamie Dimon (CEO JP Morgan Chase) mentioned widening spreads in the context of an over two-hour testimony before the House Financial Services Committee. Mr. Dimon was being questioned regarding his firms losses sustained through a London branch of JPM. It was clear that when Mr. Dimon spoke of liquidity and widening bid- offer spreads, most of his audience neither cared about his concerns nor understood the import of his remarks.
He said that this widening would affect not just rich people like himself, but also mothers, firemen, police and teachers. Mr. Dimon said he believed anyone who has a pension, anyone who has an investment manager e.g. Fidelity, using the debt and equity markets, benefited from narrow market spreads. He said simply that they need a liquid market.
Mr. Dimon was criticized in many blogs, columns and broadcast media for posturing and pandering to the public. For the sake of this argument, let us say that Mr. Dimon is dead right.
Despite attempts of his questioners to keep him on the defensive, he stood his ground and yielded no quarter. He was clear on the importance of liquidity to keep spreads narrow or tight. He even used his thumb and forefinger to illustrate narrow to the congressmen.
For some reason Mr. Dimon overlooked mentioning the crucial role futures markets have played in reducing the borrowing costs of the Federal Reserves Treasury Auctions since the futures contracts in US debt began almost forty years ago. We will mention it for him. If liquidity in the futures markets of US debt instruments decreases, the cost of borrowing for the United States government will eventually go up just as the costs of US borrowing went down dramatically after debt futures gained acceptance in the mid to late 1970's. I do not know precisely what Mr. Dimon's definition of liquidity is, but I would hazard a guess that it is not much different from what we have suggested it should be.
Mr. Dimon, the large banks, HFT's et al and the CME have their voice in Washington. Before the securitization of the CME and the stock exchanges, market makers were represented by the exchanges. Since then the interests of local market makers and the exchange seem to have diverged and market makers have little if any voice in their plight.
This conflict of interest between the exchanges' seeming desire to favor new business over old, market takers over market makers, and city hall type bureaucracy over sound business principles in their administration of the CME group policy, is in a word … unacceptable.
If you agree that something must be done to stem the decline in liquidity, the inevitable decline in volume and the resultant implosion of our franchise, please join me in my attempt to effect a change in these self-destructive policies.
Ronald T. Manaster
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