Forgive me, but that's a very romantic and slightly... out-of-date view of the market making activities. In other words, you want your average girl to be 'good' and literally lie back and think of England as you do onto her as you please? No longer true, and has been false for years.
The idea that you could force these firms to quote a fixed-width, reasonably-sized, usefully narrow, symmetrical, continuous, unconditional and two-sided prices is unrealistic in at least six out of seven respects. I mean, if you are a regulator (sounds like
, i could provide you with some solid evidence of how exactly these firms work as I've been watching them in awe for years. Let me just say here, that their overarching goal is to withdraw liquidity when the customer is most likely to need it. There are very ingenious and quite effective in second-guessing your next move. One has to develop some tools to see their actions, but it is all there for you to see, glaringly obvious and quite depressing if you think of the enormous mental effort that has been expended on devising those active market making strategies... all that lateral thinking, all that lightspeed technology, just to screw you up. How much efficient would American autos be if those fat bonueses were instead forked out in Detroit...? So you might think, but before you act on your intuition to regulate, before you reach for you carving knife, bear with me a second longer.As someone already pointed out here, apart from the reaction speed, you no longer can tell the difference between a modern, i.e. an active market maker and your median Joe-useless-program-trader (no Joannas in this field as far as I know
In fact some of these firms use separate shill quotes, pretending to be the customer! And all that to widen the spread just when you were about to trade. In fact, the competition among them does not help much, because they use the same conditioning info (i.e. your actions and the market action) and react to it in exactly the same way... yes, its a herding behavior.Regulators would probably want to turn back the clock, and force selected market makers to become passive again, extracting their socially useful function from the useless speculation, right? That was already tried before. Selected industry leaders, i.e. large, 'efficient' companies were nationalized (while others, smaller, were liquidated) and allotted monthly production targets, of tasty, healthy, durable, socially useful goods. Even grocery stores had empty shelves for decades and the authorities needed a five-meter-high wall just to stop people from fleeing. Because central planning is what you are effectively advocating. Extracting the socially useful function from the useless ones, which the government disapproves of, is a very old socialist idea. Today it looks more outdates than the Tobin's original tax rate in today's 0.00001-spread Forex. The IMF's director, Strauss-Kahn, is exactly right that modern socialists are anything but - they are all living in a time-warp, with their attemps to micro-manage the economy's every market...
I tell you that experience teaches it didn't work in diffuse, competitive, multi-agent markets. Collectivization failed miserably when applied to markets such as food production. Some socialist countries didn't even bother to extend their reign over the farmers. But those stubborn enough to force their preconceived ideas of social good, and like the Soviets marched forward with central planning of the farming industry, managed to create a famine of biblical proportions...
And your idea of a 'carve up' of the socially useful plain-vanilla market making for the benefit of the society has even more unintended consequences. First it would widen the bid/ask spreads to the max, because this is exactly what oligopoly markup pricing is all about. If you make a short visit to monopoly SPX options and monopoly ONEChigago SSFs, you might be able to taste the future you envisage... spread so wide you could park a bus between the bid and ask.
Then restricting competition among market makers by forcing them to adopt passive 'useful' strategies would only accentuate the already dangerous (according to Wilmott) herding behavior among the high-frequency traders. I mean, if there is only one (approved) market-making strategy in town, whilst others are taxed out of existence, you get from here to the portfolio-insurance-style crash in no time at all.
And last but not least: who would play the village idiot, i.e. the greater fool, the shooshine boy who puts money on the market maker's table? Commercials trading VWAP once a month? I ask you: who would bring the money to the table, by panic-shorting those painful bottoms, by chasing those parabolic 'trends' and believing in the magic presence of antigravity in price spikes?
I mean, the noise trader, the despised common speculator is important for this very reason that he (and I
will sometimes (well, usually) 'foolishly' go the 'wrong' way. Which makes him sometimes the only one to patch a liquidity hole universally created by your herding market makers. Rational models will not save markets from 'consensus' divergences - it takes the uninformed hopeful 'idiots' who will bravely step in an obvious downtrend (or usually - much earlier). Your officially approved market makers would just widen and skew their spreads and collect the winnings untaxed. What a Carve Up!