Opinion: Illiquidity and the Danger It Fosters for World Equity Markets©, Part 2 by Joe DiNapoli

Today, we can look eastward to the China Stock Index futures contract and see the similarities between its size and the size of the S&P contract back in 1986, except in China, the situation is worse. In a sincere effort to protect its citizens against the effects of margin, regulatory bodies have set the bar so high, the average trader has no hope of participating. The result is illiquidity.

Before I go further, I realize that some of you might confuse volume with liquidity. This is a fatal error. One can have little to do with the other. For accurate statistical averaging or real price discovery, wide participation by a variety of traders with vastly differing motivations is necessary. Consider two hedge funds trading a billion shares back and forth. There is lots of volume and no liquidity. This situation is not the same as a billion traders trading two shares back and forth where there is huge liquidity. Now, let's consider the so-called high-frequency traders who skim riskless profits from the rest of us in billions of dollars. They now account for approximately 60% of volume in the US equity markets, and by their actions, decrease liquidity as more and more traders learn just how unfair their practices truly are and simply stay away. My own trading volume has decreased by almost 75% since late 2008. Like Sun Tzu councils, "Avoid battles you cannot win."

Markets have internal structures, the nature of which goes beyond the scope of this article. When great masses of people trade relatively small quantities of stock, the structure is maintained in a healthy way. Liquidity providers on smaller time frames are amply rewarded. When large market operators trade huge numbers of shares between each other to attract attention to an equity, structure is undermined because this activity is not representative of true price discovery.

Pictured below is a popular stock on the KLSE in 1997. This is one of hundreds across the region that behaved in the same way.

The dramatic fall and total lack of buying on the way down can be attributed, at least in part, to well-meaning but misguided government policies in the region that prohibit legal short selling. Legal short selling is a stabilizing influence on overheated markets on the way up and crashing markets on the way down. After all, for a short seller to make a profit, he must buy on the way down. Legal short selling, however, is not to be confused with fraudulent short selling, or so called "naked short selling," another clearly illegal practice.

Before we look at the Flash Crash, let's look at some of the sources of illiquidity present in our markets today:

  1. The correct assumption that the markets are not properly regulated and are unfair to the smaller trader and even many institutional traders who are not participating in outright fraud or activities brought about by lack of prudent oversight.
  2. A significant reduction in the number of traders, both professional and private, due to the economic crisis the past two years.
  3. High-frequency traders who front-run orders using sub-penny pricing and fraudulent denial-of-service trading techniques.
  4. Computerized trading that takes near riskless profits out of markets by exploiting time differentials in microsecond intervals in various markets, thereby raising the costs for all other traders.
  5. Fraudulent short selling where it takes only money, greed, and avarice to destroy a thriving business.
  6. Markets that are no longer free to trade normally because of government policies, like money-printing on a gargantuan scale.

Let's take a look at the sub-penny pricing issue so you can better understand why such practices force traders to stop trading and thereby reduce market liquidity.

During the flash crash, a professional trader for a respected firm placed an order to buy Morgan Stanley at 13. There were no bids whatsoever in the market, only an offer at 20. Instantly a bid front-runs his bid at 13.001, so he raises his order to 14 and again a bid at 14.001 instantly comes into the market. What is happening is that his order is being front-run by a sub-penny (likely a high-frequency trading computer). The only way he will get a fill is if the sub-penny front runner is hit and decides the market is against him. Then and only then will the sub-penny, illiquidity-creating computer stuff the order to the original 14 bid. It will do this before the bid at 14 can be cancelled. The net effect of this game is that the original bidder will only get a fill if he is wrong the market. It is a heads you win, tails I lose situation. Is it any wonder liquidity-providing traders are staying away?

Now, let's look at the conditions I have described and see if the Chinese markets could be subject to the same issues.

  1. Short selling is not widely allowed.
  2. The contract size of the China Stock Index futures contract is very large.
  3. Current regulations prevent many traders from participating.
  4. Regulations also prevent certain other foreign entities from directly trading Chinese shares.
  5. Already we regularly see moves in the Chinese markets in excess of 4%.

Fortunately, up to this point it seems the majority of traders feel the Chinese market is fair. If this feeling changes, however, as it has in many parts of the world, we could easily see the same effects in China that we see elsewhere.

Chinese and other Asian regulatory bodies, however, seem to have their motivations properly centered at providing stable and well-trusted capital market structures rather than sucking up to the latest campaign contribution. If they can learn from the mistakes made by US financial markets regulators and lawmakers and adjust their policies accordingly, Chinese capital markets will develop even faster and healthier in the future than they have to date. This is a tall order, but not unrealistic if the people in charge get the necessary expertise from real traders who understand the problem. Then, conscientious regulators and lawmakers need to act on the information, not just conduct endless hearings, while what is left of Rome continues to burn.

© Copyright Coast Investment Software, Inc. & Joe DiNapoli

Joe DiNapoli, president of Coast Investment Software, Inc., has forty years of market trading experience and has been a registered CTA for over twenty-five years. DiNapoli is a long-time CQG customer, and his Fibonacci-based indicators are available in the CQG Integrated Client. He delivered a presentation on this topic at the November 2010 Traders Expo in Las Vegas and for the CME at the ATIC event in Singapore in May 2011. This is part one of a two-part opinion piece. The unedited article in its entirety is available on DiNapoli's website.

Read Part 1 >