How the New Breed of Market Makers Reshaped Trading
Recently, the Financial Times covered the rise of the so-called “algo” market makers, such as Knight Capital (KCG), which have helped reshape trading on global equity markets over the past decade. Yet, on August 1, the New York Stock Exchange (NYSE) cancelled trades in six stocks after an electronic system run by Knight Capital malfunctioned, reminding traders of the unfortunate 2010 flash crash.
The new market makers that have come to dominate US and European trading flows make bids in shares, futures, options and currencies by means of computer algorithms, which is why they are often referred to as “algo” market makers.
The growth of companies such as Knight Capital and its rivals Citadel Securities, Getco Securities, IMC and Optiver, has come at the expense of diminishing the role of market-making specialists and the NYSE itself, the FT notes in its article. Knight Capital in particular was founded in 1995 and has become the biggest market maker for retail brokers in US equity shares trading on the NYSE and Nasdaq. The FT quotes US-based exchange consultant Christopher Nagy who notes that the franchise value of Knight Capital lies in their more than 800 connections to small broker dealers.
!m(/uploads/story/229/thumbs/pic1_inline.png)The expansion of intermediaries such as Knight Capital has been facilitated by the merging of NYSE with electronic exchange Arca and the subsequent substitution of market-making specialists with designated market makers (DMM).
According to the NYSE, DMMs have obligations to maintain a fair and orderly market in their stocks, quote at the national best bid and offer (NBBO) a specified percentage of the time, and facilitate price discovery throughout the day as well as in periods of high volatility and significant imbalances. The FT notes that in exchange for providing stocks liquidity, the DMMs receive lower trading fees and the highest rebates.
And while the algo market makers are supposed to provide traders with benefits such as deep liquidity, transparency and more competitive price quoting, a recent technology failure has probably made some traders feel nostalgic about the old-fashioned “outcry” market making.
On 1 August 2012, the FT reported that the NYSE cancelled trades in six stocks, including China Cord Blood Corp (CO) and Quicksilver Resources Inc (KWK), since a computer error of Knight Capital sent stocks fluctuating by as much as 151 percent, particularly in the case of China Cord Blood Corp. As market participants said that and “algo” order had overwhelmed the market, the NYSE reviewed the trades of 148 stocks, saying that no additional stocks would be cancelled and that the decision was not subject to appeal.
The occurrence brought back memories of the 2010 flash crash, when Dow Jones slid almost 1,000 points only to recover those losses within minutes. According to the FT, traders said that the new technical error episode served as a reminder that two years after the flash crash, the stock market was still vulnerable to malfunctions by high speed computerised trading systems. On August 2, however, Knight Capital’s chief executive, Thomas Joyce, pointed out that the erroneous trading was neither the fault of the NYSE, nor his company algorithms. “It was more of a network failure problem,” he said, as quoted by the FT.
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