Rosenblatt Securities Inc.

Exchanges face threat from loss of liquidity

Thursday, January 21, 2010

By Jeremy Grant in London

While banks would be clear losers, the effects would also be immediately felt down the entire food chain of the trading world.

Liquidity on stock and derivatives exchanges would shrink in the short term, meaning there would be a smaller pool of trading activity in which participants get deals done. The same would apply to the off-exchanges markets.

That could hit the valuations of publicly listed exchanges that derive much of their volume from proprietary trading activity – such as the CME Group, the US options exchanges, NYSE Euronext and Nasdaq OMX. The same would apply to smaller platforms such as BATS Exchange and ELX Futures.

Larry Tabb, founder of the Tabb Group, a New York-based consultancy, said: “It’s certainly going to harm liquidity. You have a series of players in the market who are no longer going to provide liquidity.”

However, some believe that would not last long, as traders regrouped outside banks and set up their own “prop shops”. Christian Katz, chief executive of SIX Swiss Exchange, and a former Goldman Sachs banker, says: “The net effect, longer term, could be neutral; it doesn’t have to be a collapse.”

However, any immediate exit could benefit hedge funds and independently operated proprietary trading firms – including “high-frequency” trading firms.

Joe Gawronski, president of Rosenblatt Securities, said: “If this [ban] were to happen there would be less capital chasing the same finite number of trading opportunities, which would benefit any independently operated prop fund.”

For high-frequency firms, there could even be added market-making opportunities, though banks would still be allowed to do proprietary trading if it was related to their customer business. Banks’ trading operations will often take on significant positions in certain financial instruments to provide clients with trading in those instruments if liquidity in them elsewhere – on exchanges, or in the over-the-counter markets – is lacking. That is seen as a form of market-making and appears to have survived the clampdown on proprietary trading.

High-frequency and other proprietary traders are unlikely to feel comfortable with the intense pressure now being applied on banks over their trading activities. One trading platform executive said: “My fear is that this would be the first step. First the banks, then HFT [high frequency trading] firms.”