MARKET QUALITY: FAIRNESS VS. EFFICIENCY
Are fair markets more efficient? A study from the Capital Markets Cooperative Research Centre (CMCRC), forthcoming in the Journal of Business Ethics, has found that improving market fairness helps to reduce transaction costs, but not all market design changes simultaneously enhance both market fairness and efficiency.The research by Professor Michael Aitken, Professor Frederick Harris and Dr. Shan Ji is based on the security Market Quality (MQ) framework developed at the CMCRC. This framework relates five elements of market design to three metrics of market integrity and two metrics of market efficiency. The study investigates whether a higher incidence of market manipulation at the close increases or decreases the quoted bid-ask spreads. Using surveillance industry techniques, market manipulation is proxied by ramping alert incidence. The study shows that quoted bid-ask spreads are positively related to the incidence of ramping cases across seven liquidity deciles. The magnitude is also economically significant; a 50% decrease in the incidence of ramping reduces spreads 6 to 11%. How can an exchange-operator go about cutting ramping manipulation? The study presents evidence that auctions at the close reduce closing price manipulation and lower quoted spreads. Circuit breakers and the prohibition of short positions reduce the incidence of ramping but both these market designs substantially increase spreads, exemplifying the integrity-efficiency trade-off. Consistent with other empirical analysis, the study also finds that the number of regulations requiring real-time surveillance tightens quoted spreads in all liquidity deciles (raising trading volume) but leaves the incidence of ramping largely unchanged. The research shows that the likelihood of real-time time surveillance (RTS) system adoption rises with increased alert incidences, implementation of direct market access and in the absence of closing auctions. Exchange- operators and regulators have introduced RTS to monitor the complex and legitimate layering of orders up and down the “book”, by slicing and dicing of trading instructions, and by the explosive growth of order cancellations in continuous limit order books, particularly for highly liquid stocks. Conversely, RTS is less likely to be adopted where securities law violations are enumerated with stipulated penalties as is the case in civil-law vis-à-vis English common law jurisdictions.