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Why Real Market Liquidity has Been Shrinking for Decades

The "flash crash" is in effect the little boy who shouted out that the emperor has no clothes. It was a day that has been long in coming. The screaming great weakness in the global capital markets has long been that it is totally dependent on private capital.

There is not a penny of government money anywhere to insure that IBM is $130 bid, $130.01 offered. This was not a problem when I entered the business during the seventies, a small "old boy's" club of specialists made markets for 100 share round lots, and the business was overwhelmingly retail.

Ramp up the volume 100 fold, triple the volatility, and bring some Cray computers running top secret algorithms, and it is a different story completely. 

Just as British Petroleum (BP) punched outside the technology envelope, drilling on the Gulf floor at 5,000 feet, so have the hedge funds and high frequency traders done on the floor of the NYSE.

Needless to say, this has all taken the public's confidence in the markets and the securities industry to new all time lows. In the aftermath of the life threatening losses seen in 2008-2009, market makers are now on a hair trigger to whip their capital right out of the market.

At Morgan Stanley, they used to tell us to "stop answering the phones."

Liquidity vaporizes, creating a vacuum that lead to triple digit moves in the indexes and Dow stocks trading for pennies. To combat this, exchange officials are now pushing for the kind of daily limit moves for single stocks that have long been in force in the futures markets and foreign stock markets.

In Tokyo, for example, most shares are limited to daily move of around 10%, which proved extremely useful when Barings went bankrupt in 1995, and when NASDAQ crashed in 2000.

Here, that might mean stocks don't trade for a week when there is a surprise hostile takeover or a big earnings miss.

Expect the new rules to be implemented within three months.

If you want a smooth ride, expect to pay through the nose for some high end shock absorbers. To us stock traders, that means having to share a single bed with a gaggle of snoring regulators.

Article courtesy of: The Mad Hedge Fund Trader


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