Home » Market Structure » Hobbesian World of Market Microstructure and Science v Engineering

Hobbesian World of Market Microstructure and Science v Engineering

Matt Levine, DealBreaker, All Stock Trading Shoud Be On Exchanges, Say Exchanges, here. How did I miss this?

I’m a sucker for market microstructure papers because I like the Hobbesian world they imagine, where everyone is trying to rip everyone else’s face off, and keep their own face on, every nanosecond. The basic idea here is that liquidity providers – call them dealers – charge some price (call it the spread1) for trading shares with you. That price in part pays them for, like, hiring traders and buying computers and stuff, and in part it pays them for taking the risk that the shares they buy from you will go down and the shares they sell to you will go up. That risk should in some abstract aggregated sense be manageable – stocks go down about as often as they go up and everything should cancel out – but becomes scarier ifyou know what you’re doing. I guess some people do? It’s a particular skill; here it means being informed about the very short-term future path of stock prices – like, the time it takes the dealer to work out of the position he just took with you – and so tends to be the province of high-speed-type prop traders.

Anyway it is an unusual skill not generally found among big “real money” institutional investors, who tend to think in terms longer than five minutes. Now it turns out that if you can take the big people who don’t know what they’re doing – the Fidelities and Vanguards of the world who are mostly putting vast pools of mutual-fund-ish money to work in index-ish ways – and segregate them in one box, and then take the little people who don’t know what they’re doing – retail – and segregate them into another box, then that leaves you with a third box, which is disproportionately full of traders who have a good idea of what stock prices will do in the next five minutes, and the trick, for dealers, is just to stay the hell out of that box. That’s loosely speaking how the U.S. stock market operates: big institutional investors trade in dark pools, retail investors trade with internalizing dealers who pay brokers for order flow, and everyone else trades on the stock exchanges. Which are unpleasant places, for market makers, because they face the adverse selection risk of disproportionately buying from and selling to people who are selling and buying for a good reason:

Shane Parrish, Farnam Street, The Difference Between Science and Engineering, here. So we are Engineers not Scientists?

Here is a schematic structure of Scientific inquiry contrasted with the structure of engineering design.

The Antiparallel Structures of Scientific Inquiry

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