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March 1, 2002

Market Structure Massacre?

By Jim Marks

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The regulator's objective is fairness and transparency. Yet many of the changes in market structure - changes caused by regulation - have only produced a big, splitting headache for institutional traders.

If narrowing spreads are important, markets are arguably more efficient. But then again, markets, in one obvious sign of inefficiency, seem more fragmented. Large trades are harder to work. And the size at which an order can move the market is shrinking.

Indeed, the structures are changing at a dramatic pace, a pace that is not going to slow. The pace is likely to accelerate as technology advances, as electronic trading grows, and as stock exchanges readjust to the new conditions.

Here's a closer look at what's happening - especially on Nasdaq - and why institutional traders have that splitting headache:

Decimalization and Narrower Spreads

Fractions are gone. Within a few years, traders will be showing their age when they talk about "eighths" or "teenies." The trading process has changed, but it was not decimalization alone that caused it. It was the related decision to set the standard quote interval at a penny, the lowest whole monetary unit. The minimum increment could as easily have been set at five cents, or even half a cent. It was set at a penny.

The most significant result of decimalization and penny intervals has been the apparent narrowing of spreads, especially in the Nasdaq market. Certainly, the price differential between the best bid and best offer at any specific point in time has decreased, a development that has been hailed as a great step forward in establishing a fairer market. However, whether this has been accompanied by a corresponding decrease in effective spreads is open to debate.

Narrowing spreads have also produced a corresponding decrease in the number of shares available at the best bid or offer. The reason makes common sense. Wider spreads include more price points between the best bid or offer, thus aggregating demand or supply from each of these individual price points into a set of potential trades.

As spreads narrow, some of those potential sales or purchases are excluded from the set, producing incrementally fewer shares available within the spread and less availability.

As a result, while quoted spreads have apparently narrowed, they have effectively narrowed only for very small orders where the quoted size satisfies the trade. And since the quoted size is a function of spreads and decreases as the spread decreases, quoted size has been decreasing.

In this environment, traders with larger orders have to reach further into the book - to figure out the price at which real demand and supply lies at the effective spread. This creates confusion and inefficiency in the price discovery process for institutional traders. And more inefficient pricing for all market participants.

The irony is that the structural changes imposed on the market to make it more fair and efficient have actually made it more opaque - and more inefficient - for institutional traders with large orders.

This is unlikely to change. Academics who focus on apparent spreads as a measure of market efficiency dominate the current debate and strongly influence the regulators, who are attempting to promote the fairest' possible markets.

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