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Trading, Clearing, Custody, and the Worldwide Evolution of Exchanges as Unique Organizations Read chapter Read first chapter

2021 | OriginalPaper | Chapter

9. A Liquidity Program to Stabilize Equity Markets

Authors : Nazli Sila Alan, John S. Mask, Robert A. Schwartz

Published in: Equity Trading Round-Up

Publisher: Springer International Publishing

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Abstract

We consider a program that, by bringing additional liquidity to the equity markets, would benefit market participants, listed companies, an exchange, and the broader economy. Established by an issuer, managed by a third-party broker-dealer intermediary, formally structured and maximally transparent, the program involves corporate share repurchase in a falling market and issuance in a rising market. We use simulation analysis to assess the procedure for 30 Dow and 30 DAX stocks for the 5 year span, 2008–2012; our findings indicate that the program can generate profits for firms that institute it, and we suggest that additional steps be taken to refine, further test, and implement the procedure.

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previous chapter Unraveling the Complexity of Market Structure
next chapter Invited Editorial: Combatting Turbulence in the Equity Market—Get the Listed Companies on Board
Appendix
Available only for authorised users
Footnotes
1
See Schwartz and Whitcomb (1977), Hasbrouck and Schwartz (1988), Lo and MacKinlay (1988), Fleming and Remolina (1999), Stoll (2000), and Bessembinder and Rath (2008).
 
2
This design feature would put our proposal above and beyond the level of transparency already established as “Accepted Market Practice” in France, Portugal, Netherlands, and Italy. (Source: http://​www.​esma.​europa.​eu/​page/​accepted-markets-practices)
 
3
See Schwartz (2009) for an earlier mention of the public good attribute of price formation that likens the public good provided by an exchange produced price (it sheds light on share value) and the public good provided by a lighthouse (it signals the location of a harbor or the presence of a rock).
 
4
One proposal is a “Tobin” tax on trading, the primary objective being to discourage participants from flipping quickly in and out of positions. We see irony in this. First, HFT players have been thought of as the new market makers; if indeed they are, why make it more difficult for them to enter their orders in the first place? Further, in light of the considerable regulatory attention which has been given over the years to lowering transaction costs by reducing commissions and bid-ask spreads, why should government then impose a tax on trading that raises transaction costs?
 
5
We would like to thank the Deutsche Börse Group for having provided the data.
 
6
The composition of the DOW index was changed four times throughout our sample period; for the latest constituent list, 26 stocks were included in the index for more than 90% of our sample period.
 
7
Including the most prevalent DAX stocks resulted in 29 of the sample stocks being included in the index more than 80% of the time.
 
8
In call auction trading, liquidity provided stability and reasonably accurate price discovery are brought into alignment in a way that is not possible to achieve in continuous market trading, as we discuss in section “Call Auction Prices and Equilibrium Values” of Appendix. It is important to emphasize that, when this alignment is achieved, excess volatility can be dampened without perturbing a proper adjustment of prices to new information.
 
9
The SL tests derive power because they do not presuppose any specific pattern of mean reversion or trending (such as would a more standard autocorrelation test). This is important because correlation patterns shift over time, both in terms of sign and duration, and because stock returns can reflect a mixture of autocorrelation patterns of first and higher orders.
 
10
Vulnerability to gaming is considered further in Section “An SL Program and Gaming Possibilities” of the appendix.
 
11
Given that the program executes based on price movement and not on inventory, there should be no cause for concern regarding any rebalancing activity. Additionally, cause for concern in the event of a hostile takeover and/or short-squeeze situation is also unwarranted, as this can be adequately addressed by the inclusion of a tapering function.
 
12
In one benign way, however, a company can, if it so wishes, rebalance its portfolio without decreasing the size of its publically announced SL orders: if it has an undesirably large short position, the company can rebalance by augmenting its SL buy orders; similarly, if it has an undesirably large long position, the company can rebalance by augmenting the size of its SL sell orders. Alternatively, it can taper its order sizes as we have done in our empirical tests.
 
13
Under certain conditions (e.g. the advent of potential bankruptcy or an unexpected hostile takeover), a company should be allowed to alter the parameters of its SL program without delay.
 
Literature
Alan, N. S., & Schwartz, R. A. (2013). Price discovery: The economic function of a stock exchange. Journal of Portfolio Management, 40(1), 124–132.CrossRef
Bessembinder, H., & Rath, S. P. (2008). Does market structure matter? In Stock market liquidity: Implications for market microstructure and asset pricing (pp. 149–172). Hoboken, NJ: Wiley.
Fleming, M. J., & Remolina, E. M. (1999). Price formation and liquidity in the U.S. treasury market: The response to public information. Journal of Finance, 5, 1901–1915.CrossRef
Hasbrouck, J., & Schwartz, R. A. (1988). Liquidity and execution costs in equity markets. Journal of Portfolio Management, 14, 10–16.CrossRef
Lo, A. W., & Craig MacKinlay, A. (1988). Stock market prices do not follow random walks: Evidence from a simple specification Test. Review of Financial Studies, 1, 41–66.CrossRef
Schwartz, R. A. (2009). Dark pools and fragmented markets. Annual Report and Statistics. World Federation of Exchanges, pp. 16–21.
Schwartz, R. A. (1988). A proposal to stabilize stock prices. Journal of Portfolio Management, 15, 4–11.CrossRef
Schwartz, R. A., & Whitcomb, D. K. (1977). The time-variance relationship: Evidence on autocorrelation in common stock returns. Journal of Finance, 32, 41–55.CrossRef
Metadata
Title
A Liquidity Program to Stabilize Equity Markets
Authors
Nazli Sila Alan
John S. Mask
Robert A. Schwartz
Copyright Year
2021
Book
Equity Trading Round-Up

Print ISBN: 978-3-030-51014-5

Electronic ISBN: 978-3-030-51015-2

Copyright Year: 2021

DOI
https://doi.org/10.1007/978-3-030-51015-2_9