This is Part II of a series of posts examining alternatives to the Continuous Double Auction market. Part I, posted at my CASTrader Blog, examines the problems with Continuous Double Auctions. This Part II examines some existing alternatives to them.
Invention of new types of markets has experienced a relative renaissance in recent years (mainly by the people who hang around Midas Oracle), many of which I surveyed before on my blog, and new types of markets are being invented as we speak (PDF). It’-s hard to keep up, and I will caution that I am by no means any kind of expert on market design. That said, let’-s examine an old-school market, as well as one of the new inventions.
Call Auction Market. Ironically, what the New York Stock Exchange replaced in the 1800s when they adopted CDAs has some interesting properties and advantages. A call market is typically organized as a price scan auction which basically amounts to this: poll every market participant and ask them how much they would tenatively offer to buy or sell at a given price. The search continues until buy/sell demand is balanced, at which price the market is cleared. The call market was rightly abandoned in the 1800s as markets grew due to the impossibilities of managing them in the pre-electronic era. I imagine it was mind-numbingly boring for traders as well. Recently, though, other types of call markets, such as crossing networks that batch orders at prices set in CDA markets have re-emerged, and some researchers have called for a major revival of the old call market (you may want to turn your sound off before clicking that link). Call markets have the interesting property of higher liquidity and lower short-term volatility relative to a CDA. When you realize CDAs are a sequential operation, and call markets are batch, it’-s easy to see why this is true. In a batch operation, buy and sell orders are likely to offset, keeping price movement to a minimum vs. a bunch of sequential order fills alternating at the bid/ask. The advantage shifts towards price-takers, resulting in more trading and better price discovery, in my opinion. It’-s not hard to see that a call auction where everyone’-s offer was secret (and treated equally) would eliminate many of the shenanigans of CDAs. The following was said of call auction markets:
“Recent advances in computer technology have considerably expanded the call auction’-s functionality. We suggest that the problems we are facing concerning liquidity, volatility, fragmentation and price discovery are largely endemic to the continuous market, and that the introduction of electronic call auction trading in the U.S. would be the most important innovation in market structure that could be made.”
That was said over 10 years ago, and it’-s not hard to see why call markets are attractive, so why aren’-t they taking over? Aside from call market proponent’-s conspiracy theories that the bad boys of Wall Street would lose out, there is the major problem of immediacy. You just don’-t trade a call market whenever you want to. The now defunct Arizona Stock Exchange was a call market that cleared once a day, for example. While some might argue that clearing once a day is a more productive use of people’-s time, so long as some other market is clearing the same securities continuously, trading will flow to the other market, because there are simply more opportunities there.
Hanson’-s Combinatorial Market. I’-ve been fascinated by Hanson’-s combinatorial market, although I must admit I don’-t fully understand all of it’-s intricacies. This market doesn’-t use a limit order book at all (unless you want to use one because you want it to scale well), liquidity is always present via a market maker, and there is no bid-ask spread, because the price you pay is a continuous function of how much you want to buy or sell. The less the amount, the less your price will diverge from the last trade price. In the absence of other friction, the smallest trades are possible, even efficient, because liquidity is continuous (via a market maker that has a continuous price function). What’-s more, you can have a functioning market with just a few traders, unlike a CDA. Hanson’-s market is designed to function well in thin markets. Unfortunately, all of these characteristics are provided by one market maker adapted more for event markets than securities markets. This market maker decides what the price will be rather than the market players themselves. Furthermore, the market maker can be set up with different behaviors (scoring rules) and is subject to losing money (although the bounds of the loss is known ahead of time). While Hanson’-s market maker may be an ideal way to subsidize liquidity in a fledgling prediction market, it doesn’-t appear to me to be adaptable to a securities market.
The ideal market. An ideal dark market for CASTrader would be one that operated continuously, scaled well, and is general purpose like a CDA, while having the efficiency, volatility and trade encouraging characteristics of a call market, combined with the continuous liquidity and ability to function in thin markets of Hanson’-s combinatorial market. To boot, I’-d like it to be fair to traders of all sizes, as well as easy to program relative to a CDA. Is that possible? See Part III, over at CASTrader.