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Market liquidity - favouring electronic markets over pit trading

17 January 2014

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Those who think that the tech race towards electronic trading has led to illiquid markets have forgotten what the world looked like only 15 years ago.

Having traded the markets since 1985, I would like to explain what market liquidity actually meant in the pre-electronic days and what it means in the world of electronic trading.

During the 1987 October crash, Black Monday, I was a junior trader in government bonds and futures. Black Monday was not a crash which was over in seconds or minutes; no, the world stopped turning actually for days. The mini crash of 1989 had a similar pattern. Chernobyl 1986, Gorbachev crisis in 1991 and UK election day in 1992, were all similar liquidity gap events seen by market traders.

The beauty of those days (the late 80s) for a trader, was that markets were very often in a ‘fast market’ condition. This meant that one was able to trade at any price and all rules were thrown overboard until the board officials were able to control the pit again. Without computers, we simply could not deal with the enormous amount of activity in the markets at those times and simply stopped (or delayed) sending price information out, not just for seconds, but minutes and even (during the week of Black Monday) days. Clearers had backlogs to clients for days.

What investors, customers, institutions looked at in those days were screen prices on systems like Reuters or Bloomberg: feeds fed by the voice of the official. If the official did not yell a price in the mic, the data group would not enter a price, and the world would never see this price. Under fast markets no prices were entered and the screen would just read ‘fast’ (if you were lucky). Future and option prices on screen were seen as tradeable prices and in slow markets they may have been pretty close to the truth. In fast markets they were inaccurate and it was not possible to trade the price indicated on the Reuters screen. Yet the world still thought this was the correct price.

Being in the pit, one cannot keep buying or selling an instrument, so traders would hedge their positions. Hundreds of times I have been in situations where there was simply no bid or offer in the instrument to hedge in. The signal from a broker out of the futures pit simply stated, ‘no bid, no bid’, yet all the screens where showing a bid or an offer. Was this liquidity? The world clearly thought it was, but we all knew there was panic on the floor and you were lucky to trade one lot.

I remember the morning after the Tories won the elections in 1992 (UK). The markets opened early that day. The FTSE 100 future was quoted with a spread of 50 points and traded about 250 points up at some stage in the first few minutes of trading. With 5 to 10 futures you moved the price down or up 50 points. Was that a liquid market?

In cash markets it was no different. On the LSE, after the Big Bang in 1986, you had to call the market maker on SEAQ and ask politely how much he would bid or offer in a stock and one could then trade with the market maker. The reality was that in volatile markets, or when there was unexpected news in that specicfic stock or sector, the phone was not answered at all untill the bid-ask price had moved. I remember the day one bank froze the FTSE 100 index during an expiration by moving all the prices of stocks to one side, so the bid was higher than the offer shown on screen in all stocks, and fixed the expiry level. Trading with the bank was not possible as their phones happened to be down. After 20 minutes they changed their quotes and all of a sudden they answered the phone again. Call that liquidity?

In the French pit on the MONEP in those days it was not called market abuse if a trade happened at for example 4 francs, whilst someone else was bidding 5 francs. The excuse was clearly, “oh, I did not hear you.” Many officials were corrupt and did not intervene. For years customer orders were executed this way. For years the regulator was hard to be found and was not even interested in protecting the pricing for the end customer. I wish Mr. Barnier had been involved then. Was this liquidity?

Thanks to electronic trading, the dark days, described above, are over. It seems people often forget how fortunate we are today. The information we are dealing with on exchanges and platforms is publicly available, not just to members of the exchange in a millisecond. The information is stored and kept for potential market abuse analyses and other surveillance analyses. It is not possible to trade lower than a shown bid or higher than a shown offer. The best price always wins and is filled first. What you see is what you get because you can trade it. No fake liquidity is shown. Be glad we live in 2014! 

Critics of electronic trading often mention that we deal in too many decimals. Yes, we are able to work through computers in 3 or 4 decimals and can improve our price many times per second. We also decrease the difference between the bid and ask price as we control our risk better and the trading and clearing fees have come down. We can now see all the price changes, the real order size and actually really trade on them; this was not possible before electronic trading. Yes, today you need engineers, analysts, high-end computers and data space with reliable data lines (no internet connection) to analyze the flow of public data.

And I DO believe we can still improve things: the systems malfunctions, glitches, and so on. The industry as a whole has a job to do, including exchanges and platforms. The fact remains that current markets are a huge improvement over the past and it is the responsibility of all participants to strive towards continuous improvements. Before, the physical strength of a trader, his voice, his spot in the pit and his brain alone were the key ingredients. You decide yourself which world is better for price transparency and liquidity.

The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.

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