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December 1, 2000

Pessimism in The Trenches: Survey Finds a Crumbling Market Structure

By Editorial Staff

The U. S. equity markets have become less liquid, more volatile and fragmented, according to a survey of institutional traders conducted by Robert A. Schwartz and Dan Weaver, finance professors at Baruch College in New York City. The survey examined a range of market structure topics, including the impact of regulation and the ability to execute orders in size. On the sellside, 277 traders responded out of 2,500 polled; 56 responded out of 160 on the buyside. (See charts for highlights).

Do the findings raise troubling implications for the future of the markets? The authors of "Opinions on the Quality/Efficiency of U.S. Equity Markets" think so.

Traders Magazine spoke with them.

TM: What prompted the survey?

Schwartz: Over lunch last May, we asked ourselves how industry participants think the technology impacts and regulatory changes of recent years are effecting the quality of our equity markets. There has been a lot of public debate, but we did not know what a broader response might be. A few days later we decided to run the survey to find out. Soon we were talking to the Security Traders Association about the sellside and to TraderForum about the buyside. Both organizations stepped forward, and the rest is history.

TM: If you want to know about market quality, why not just look at the statistics?

Weaver: Market quality' is an ambiguous term. How do you define liquidity, or measure market impact costs? Fragmentation is very much in the eyes of the beholder. Yet we all know illiquidity when we see it. So, we took the direct route. We asked people what they think.

TM: Were the sellside and buyside responses generally consistent?

Schwartz: Yes. For instance, we asked about another indication of market quality, the ability to execute orders in size. The sellside said that orders are being broken up more frequently, and that investors are showing them less of their total order size. The buyside concurred, citing larger order size and increased market impact costs as the cause.

TM: Can't liquidity be measured, or at least proxied, by the bid-ask spread?

Weaver: Some people think so. Unfortunately, excessive focus on the spread can result in misshapen public policy. Narrow spreads reduce costs for small traders, but if they are associated with less depth, large traders may see their costs increase. One reason for all the attention given to the spread is that it is easy to measure. The quality of price formation is not.

TM: What did you find with regard to market quality?

Schwartz: The preponderant response on both the sellside and buyside is that liquidity is less, and that volatility and fragmentation are greater. For the buyside, markets are less transparent and trading costs have increased. But the sellside feels that markets are more transparent. Apparently, transparency is also in the eyes of the beholder.

TM: What did the respondents think about the contributions of technology and regulation?

Weaver: Both sides were very positive about technology's impact, but not about regulation's impact. Only 40 percent of buyside and 31 percent of sellside respondents felt that regulation's broad contribution was either constructive or very constructive.

TM: What bottom line conclusions do you draw from the study?

Schwartz: The respondents predominantly feel that market quality has deteriorated in recent years and that major market structure issues have not been properly resolved. Technology is a great tool, but it has to be used appropriately and market structure regulation is not helping.