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Spreads Need to Be Widened
In the late 1990s, marketmakers would regularly artificially inflate the difference between what a buyer paid for a stock and what a seller got the so-called spread in order to boost the marketmakers' profits. That drove up the cost of trading stocks. In order to stop that, regulators forced the Nasdaq and the NYSE to open up their markets to competition. New electronic exchanges popped up. Spreads narrowed in many cases to as little as a penny, sometimes less and that brought down the cost of trading.
It also drove the marketmakers and specialists, who are the people who stand on the floor of the NYSE finding buyers and sellers, out of business. Computers now do much of the function of buying and selling stocks. Most days it works well. On May 6, not so much. Computers, unlike actual marketmakers, will not step in to provide liquidity when stocks plunge. In fact, computer traders have the opposite effect: they all basically move with the tide.
One solution would be to mandate that all stocks have a minimum spread even a few pennies would make marketmaking more profitable and give an incentive to specialist firms to buy in and calm the markets.
"We need to bring more people back into the market who are motivated to keep things efficient and orderly," says Robert Schwartz, a professor who studies markets at the Zicklin School of Business at Baruch College. "That used to be the specialists' raison d'être."
Make Public Companies Provide Liquidity
Another way to make sure stocks don't plunge for little reason is to force public companies to put up capital to back their own stocks. Every company with publicly traded shares would have to keep a certain amount of money stashed at the exchange where their stock trades. If that company's shares start to fall, the specialist would use the company's cash to support the stock. It may sound like manipulation, but it's not that different from when a company buys back its stock today.
"We all get to see the prices of stocks as they go by on the bottom of CNBC, but there are a lot of ingredients that go into those prices," says Robert Iati, a partner at financial technology research firm Tabb Group. "And many of those ingredients are mixed outside of what we see."