The de-mapping of markets
June 29, 2011
Maps from the 15th and 16th centuries, depicting the world as it was known then to Europeans include distinct ‘white’ areas where little or no details about a certain area are given, or in cases where the mapmaker took a degree of literary freedom, the map stated ‘here be dragons’ in such areas. Gradually, of course, these areas of terra incognita were filled with routes of rivers and the names of mountain ranges, as maps contained more information about the world.
This process, of mapping the world, seems to be happening in reverse in financial markets, especially as electronic trading and order-matching establish their dominance in the markets. Perversely, as markets become more transparent and as representations of prices, orders and volumes become more ubiquitous, there seem to be a growing gap between the market as it seen on the screen and between the full extend of opportunities and risks that are present.
What can be driving this de-mapping of markets? To explore this, let us trace briefly the processes that drive the mapping of markets, the forces that increase the accuracy of markets’ representations. Broadly speaking, an increase in the ability of actors to express their sentiments regarding the market, with financial instruments such as derivatives, and an improvement in the detail and accuracy of the information provided by the trading venue would improve market transparency. The rise of financial derivatives and of electronic trading are related, but the latter is more relevant to the de-mapping.
It is true that markets that present more clearly the orders sent to them and allow actors to trade against these orders immediately provide more information than markets where orders are concealed from some of the actors, as was the case, in effect, in many of the specialist-run markets of the past. However, actors are aware that by placing order to a transparent market they may also expose more information than they wish to share. In turn, they may decide to hide that information. Such information, about, say, a big order, can be hidden ‘in the open’, by splitting it into small, inconspicuous orders. Yet, many market actors may decide, as many actually did, to avoid sending orders to such ‘well-lit’ markets altogether and instead opt for more ‘private’ options.
The rise of ‘dark pools’ is the most noted outcome of that quest for relative privacy and selective disclosure of information to the market. This trend results, as commentators observed, in an increasing fragmentation of markets and an overall decrease in liquidity available. Consequently, the representations we do have of markets become less and less reliable. There is more ‘out there’ than the screens of the exchanges and ECNs can capture. This is a risk, of course, as this situation is akin to sailing in uncharted waters, only that in these uncharted markets, the dangers may not come from southward wandering arctic icebergs, but from big transactions, reported ‘to the tape’ only after the fact, that may shift prices unexpectedly.
The risk of markets’ de-mapping also comes from the fact that, at its core, there as a vicious circle, or a counter-performative engine: the more transparent electronic markets are designed to be, to less attractive they would be to the ones who have something to hide. Unfortunately, since the ones who wish to hide their trades are also, usually, the ones whose trade actually move the market, the success of electronic may bring about their own demise.
(The thoughts expressed in this post owe a lot to the notion of ‘toxic transparency’ as it was expressed by Steve Wunsch.)