Of course, correlation does not imply causation

July 18, 2014 6:53 PM

Early in 1994, Christie and Schultz published "Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?" noting that although the minimum price variation was an eighth of a dollar, the vast majority of quotes and executions occurred on quarters of a dollar. Later the same year, Christie, Harris, and Schultz published "Why did NASDAQ Market Makers Stop Avoiding Odd-Eighths Quotes?" with the following abstract: "On May 26 and 27, 1994 several national newspapers reported the findings of Christie and Schultz (1994) who cannot reject the hypothesis that market makers of active NASDAQ stocks implicitly colluded to maintain spreads of at least $0.25 by avoiding odd-eighth quotes. On May 27, dealers in Amgen, Cisco Systems, and Microsoft sharply increased their use of odd-eighth quotes, and mean inside and effective spreads fell nearly 50 percent. This pattern was repeated for Apple Computer the following trading day. Using individual dealer quotes for Apple and Microsoft, we find that virtually all dealers moved in unison to adopt odd-eighth quotes."
posted by d. z. wang (10 comments total)

Awesome.
posted by grobstein at 6:56 PM on July 18, 2014

And with HFT market makers now there's no chance of that sort of clubby market making returning.
posted by jpe at 7:04 PM on July 18, 2014 [1 favorite]

The Invisible Hand moves in mysterious ways.
posted by BungaDunga at 7:05 PM on July 18, 2014

This is cool, but not surprising (to cynical ol' me, anyway) and ... old news. AFAICT (without being a Market Maker), this says that MM didn't bother dicking around with 12.5¢ orders, until somebody pointed out / discovered that there was money to be made by doing so. Then people started making money there. It's only half as much money as people were accustomed to make, but it was being left on the table. And when people started scooping that up, other people stopped leaving it there. Joe Littleguy benefits, at least by not being fleeced for the 12.5¢.

I'm having difficulty understanding how this is different in principle (rather than amount) from the millisecond / millicent stuff that HFT people do. I understand that HFT has such high cost to play, and such potential gain, that it's an effective tax on the poor and slow, but this is what the Invisible Hand is supposed to do, isn't it?

(Of course, I understand that the Invisible Hand is basically optimization, and it's directed at optimizing things that turn out to be bad for human society, but ... you tend to get what you optimize for, and until the poor and slow understand that, the rich and quick will continue to get what they like. (I wish I didn't automatically connect failing schools and student loans with "poor and slow," but I can't help it.)
posted by spacewrench at 7:27 PM on July 18, 2014 [1 favorite]

The really big change was the move to decimal quotes in 2001. Spreads are tiny now compared to when they used fractions.
posted by bhnyc at 7:31 PM on July 18, 2014

The studies call it an implicit agreement that stocks weren't traded with odd-eights spreads. I'd love to know if it really was implicit or if there was an explicit gentleman's agreement made in a smoke-filled room somewhere. I suppose there's no way to find out now.
posted by double block and bleed at 10:42 PM on July 18, 2014

The people in charge of this stuff all know one another, they come from the same class and the same schools, and are probably in the same gentlemen's clubs or whatever they call them. Honestly, even Adam Smith said that when the Merchants meet they conspire to fleece the public, and its the same today.

So colour me completely unsurprised that this happened pretty much en-masse.
posted by marienbad at 3:31 AM on July 19, 2014

Why don't these traders put some of their profit in my account?
posted by clvrmnky at 6:14 AM on July 19, 2014

Someone probably had a legacy system that was hard coded with the assumption that no-one would trade in anything under ¼.
posted by scruss at 8:51 AM on July 19, 2014

Given the various ways to game market making (front running, etc)., if I was going to just wildly speculate about motivation, it's probably worth remembering that between 1935 and, say, 1980, the stock market was a tidy, reasonably efficient mechanism for providing capital for businesses at a reasonable rate. The 'schemes' we see in retrospect are not unlike loan sharks and the vig -- people who are running near monopolies become complacent and entitled. A worker with an effective sinecure (union, government jobs, tenure, family businesses) aren't incented, but start to see existing benefits as birthrights that cannot be removed.

It's an interesting problem of capitalism. Actors, be it individuals or companies, are constantly seeking alpha (returns in excess of median) but everyone thinks they can find it and deserve it, when in fact, an effectively operating market should rationalize out alpha the moment it's observable. So you start stretching your smoke breaks longer? You just found the alpha in your hourly rate. Of course market makers were aware of what they were doing.

But once financial services became an outsized actor in the American economy, it consumes itself. Alpha comes from asset stripping, saddling companies with debt and extracting fees -- all the rent seeking endemic to private equity, LBO shops and hedge funds. The returns of the financial services firms siphons off actual wealth, but demands returns an ever increasing rate relative to their own and it's a feedback loop that can't be stopped.
posted by 99_ at 4:48 PM on July 19, 2014 [1 favorite]