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April 17, 2013

Of Frogs, Boiling Water, Market Structure and Trading

By Tom Carter

Tom Carter

The metaphorical story of the frog and the boiling water is illustrative of current market conditions and, more significantly, the position in which current market structure has placed market participants.

The tale is as follows:

If a frog jumps into a pot of boiling water, it will immediately recognize the situation as bad, and hop out.  Conversely, if a frog is placed in a pot of cold water, and the temperature is gradually raised to boiling, the frog will not recognize the subtle temperature changes, will not hop out, and eventually will die.

The water and the pot are the current market structure. The frog at this point is virtually any market participant.

Just a brief review of the breadth and depth of difficulties show how gradually market structure has boiled over, and now it is virtually impossible to hop out:


  • The decline in confidence in equity markets and an attendant decline in market volume
  • The end of penny spreads and the effect on small and midcap trading
  • The move to a maker-taker model, designed to advantage parties other than investors
  • The move of exchanges from a semi-public utility membership model to for-profit
  • The rise of HFTs and the attendant skittishness of institutions to participate in trading
  • The fragmentation in market centers and trading venues
  • Machine trading (for example, look at BATS’ ability to offer its IPO
  • BATS’ machine difficulties related to securing best price
  • The demise of Knight Capital
  • The 83% decline in profits for GETCO, once touted as the “new (but risk averse) market maker”The decline in traditional dealer activity, and their willingness to assume risk
  • The problems NASDAQ experienced with the Facebook IPO
  • A significant decline in IPOs, as companies moved to the PE and VC arenas for financing.


Where We are Now And Participant Inertia

Over the course of the last several years, JonesTrading has issued a number of papers covering critical issues and offering perspectives, as have numerous other market participants. What seems to be lacking is the ability to generate a conversation on anything other than on an incremental basis, rather than looking at the entire market structure. And it is this incrementalism, and the passive acceptance of it, that slowly is increasing the water temperature without reaction from market participants. The last comprehensive analysis of U.S. Markets by the SEC was the Market 2000 Report, which was shelved by the Chairman Levitt when he took office.

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