A day of wild swings Thursday was followed by a morning of wild swings Friday. After trading as high as 8849.22 early on, the
Dow Jones Industrial Average
was recently down 1.75% to 8647.77, while broader averages' early gains had been dramatically pared.
Thursday's VIX spike and Friday's weak consumer sentiment report were partially responsible for the market's vacillations. But another contributor to the heightened volatility, and potentially the market's recent weakness, is the ongoing reluctance of many Wall Street firms to commit capital to market-making activities.
"The sell side is less willing to commit capital than it was two or three years ago," acknowledged Anthony Cecin, managing director of Nasdaq trading at U.S. Bancorp Piper Jaffray in Minneapolis, which makes a market in 700 stocks. "You've got to be a realist. You're not going to make money committing capital" in this environment.
U.S. Bancorp and other firms are still committing capital every day -- to not do so would mean losing the institutional clients they so covet. But "I don't think the market-making community is carrying any meaningful inventory overnight," Cecin said. "To do so is folly. Is that adding to increased volatility? Probably."
Market makers, or "specialists" on the
New York Stock Exchange
, play a complex and evolving role in the financial firmament. But in a nutshell, they act as conduits for order flow between buyers and sellers, helping to ensure "orderly" markets in given stocks. If necessary, these middlemen (and women) will "use their capital to bridge temporary gaps in supply and demand and help reduce price volatility by cushioning price movement" as the Big Board's site describes.
This function is particularly crucial when mutual funds facing redemptions and other participants suffering from big losses may be looking to exit big positions in rapid fashion -- that is, times like these.
But in reality, financial firms have become increasingly reluctant in recent years to use their own capital for such purposes, thanks to what Cecin called a "perfect storm" that has dramatically reduced the profitability of market making.
The first wave of the storm occurred in 1997, when new order-handling rules were adopted that forced broker/dealers to post limit orders with electronic communications networks (ECNs) or other "third market" participants. The second wave was
decimalization in 2000, which shrunk spreads further still. When the order-handling rules went into effect in Jan. 1997, the average spread between the bid and ask price for a Nasdaq stock was 1.72%, according to the exchange. By May 2002, the average was 0.16%.
Add to that a brutal bear market that has resulted in a decrease in trading activity, further weighing on market market's returns. For example,
Knight Trading Group's
earnings fell from $2.04 per share in 2000 to 30 cents per share in 2001. The company lost 10 cents per share in 2002's first quarter and is expected to lose another nickel per share in the second.
Knight has been dogged by regulatory woes, but its results serve "as a proxy on where market making profitability has gone," Cecin suggested. "They went from being a cash cow to losing money."
The point here isn't that we should feel badly for market makers, but understand that if they are suffering, a crucial lubricant to trading is missing, which affects all participants.
Big and Small Feel the Pinch
"I can tell you that there is NO and I mean NO liquidity," emailed Brad Ruderman, managing partner at RCM Partners, a Los Angeles-based hedge fund with about $100 million under management. "You can't buy or sell size
and I can speak from experience that it has been that way for a while."
Indeed, many market participants say recalcitrance by market makers is nothing new. One hedge fund manager said he's increasingly employing options as "preventive medicine" to deal with the absence of liquidity. To avoid being stuck in positions if the market swings wildly in either direction, the hedge fund manager will buy puts to offset long positions and conversely acquire out-of-the-money calls to offset shorts. This protects from big losses but also eats into profitable trades due to the cost of the options insurance.
It's arguable whether the volatility is causing broker/dealers to lessen their capital commitment or vice versa. But this issue does impact all market participants, even the institutional giants.
"We have the clout, but it doesn't mean we're getting the response" we'd like, said Diane Garnick, global equity strategist at State Street Global Advisors, of the world's largest asset managers. "The way it's impacting us is we have same number of broker/dealers competing for our dollars, buy they're not as competitive with their prices." (Conversely, broker/dealers say institutions like State Street are increasingly squeezing them by demanding ever-shrinking transaction fees.)
Compounding the problem is the recent consolidation where stand-alone market makers and specialists were acquired by financial services giants and banks. In 2000 and 2001,
acquired Herzog Heine Geduld;
bought Wagner Stott Mercator; and
acquired Spear, Leeds & Kellogg and Benjamin Jacobson & Sons. Elsewhere,
acquired National Discount Broker and
acquired M.J. Meehan.
In case you hadn't heard, those firms are dealing with multiple issues beyond decimalization, including heightened regulatory scrutiny, losses from loans to/investment in corporate miscreants like
, as well as Argentina and Brazil. Crucially, the ongoing bear market has eroded revenue in investment banking and M&A. These areas traditionally produced the bulk of broker-dealers' profitability and helped underwrite market-making activities.
FleetBoston, which is
struggling to unload its Robertson Stephens investment banking unit, is a prime example of how financial services firms are suffering a dearth of revenue in on area that, again, has contributed to a reluctance to commit capital to market making.
"Several banks haven't positioned any stocks in ages," quipped one money manager. "You can't lose
the money if you don't bet it."
The Good, the Bad and the Ugly
The good news is that despite this confluence of negatives, the market still seems to be operating fairly smoothly.
"For this amount of selling pressure it's surprising how orderly it's been," observed Nick Moore, a portfolio manager at Jurika & Voyles, an Oakland-based money management firm with $2 billion in assets. "Not only are stocks not trading 'bid wanted', you can move a 20 million share block of WorldCom." His point is that despite perceptions to the contrary, there is liquidity in the market, even if it's not coming from market makers.
Still, for as bad as it's been, it hasn't been ugly, Moore conceded. The "real danger," he suggested, is the erasure of five years worth of gains -- as measured by the S&P and Comp -- could be the "psychological straw" that prompts retail investors to flee from the market
Veteran participants recall that the October 1987 crash accelerated because market makers and specialists refused to step into the breach and use their capital to stem the decline. That is, until newly elected
chairman Alan Greenspan assured Wall Street the central bank would back them up. (This was the first in a long line of morally hazardous actions by Greenspan, but that's another story.)
Most sources believe "we're a long way" from 1987, as State Street's Garnick suggested. "I don't see that happening, especially not in the short run."
One reason is that ECNs and other third-market participants are a much bigger component of trading today vs. 1987. ECNs such as Instinet and Redi-Book handled 41% of over-the-counter trade volume in May 2002 and 36.2% of the dollar volume of trading, according to Nasdaq.
"In 2002, the market-making community is but one component in the marketplace of open-ended architecture," Cecin said. "I don't feel any obligation on my part to be buyer of last resort. I'm just another player in the game."
In other words, if the stuff really hits the fan, don't expect market makers to provide a life raft. They'll be going down on the same ship as the rest of us.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.