Marketside chats #5: Market making

This article will focus on the role of a market maker (MM) in the securities (financial instruments) markets. Let us start by talking about some other well-known markets.

Role of intermediaries

Some markets have no intermediaries:

  • open-air farmers’ markets involve fruit & vegetable sellers selling directly to the buyers.

Some markets have intermediaries, but those intermediaries only act as brokers/agents who bring together already existing buyers and sellers for a fee:

  • real estate agents are not in the business of buying houses in the expectation that they will resell it to another buyer for a profit (although they sometimes do).
  • used book sellers on the Amazon marketplace (TM) pay Amazon a fee for being able to post an offer price for books they own and want to sell. Amazon acts as agent, and does not take any risks, such as pricing risk (what if an expensive college textbook stops getting used in colleges, or has a new edition?), or liquidity risk (what if no buyer can be found for a book for an entire year?).

Some markets have intermediaries who either act as brokers/agents or principals/dealers (or sometimes both, though not for the same transaction). A principal/dealer buys with the expectation to sell later, but possibly incurring risk in the meantime:

  • Car dealers often will buy a used car that is traded in. They mostly do it to profit from the (typically) new/newer and more expensive car they will sell to the person who brings the trade-in. However, they aim to buy the traded-in car at a low price so they can profit from marking it up to its next buyer.
  • Some real estate investors – such as the ones who send you those “we buy houses” postcards in the mail – act as principals by buying houses cheaply when they can, and selling them for a higher price. They usually buy and improve a house without first having another buyer lined up to sell to.
It is difficult to find an exact real-life analog to securities MMs, as one can make an argument that the intermediaries change/improve the product in each case above. For instance, car dealers may add extra warranties and/or the benefit (or illusion of benefit) that they performed safety checks. Some real estate “flippers” fix up homes with the expectation that their repairs increase the house price by more than the cost of the repair.

Securities markets participants can roughly be divided in this way:

  1. Those with an opinion/bet on the price of a security: e.g. investors (retail traders, pension funds, etc.), hedgers (e.g. a farmer who wants to insure against price volatility of his produce), or speculators who want to bet on/against a security.
  2. Those who have no exposure to prices of securities: e.g. agents/brokers. Note that only exchange members (i.e. not you or I) can trade directly on the stock exchanges, so a broker has to do it on our behalf.
  3. Those who acquire exposures to prices, but typically don’t want to: e.g. principals/dealers (the subject of this article).

Cost/benefit of being a market maker

A MM is a dealer who has the right (and, usually, the obligation) to make a two-sided market by posting a bid and an offer (i.e. an order to buy and an order to sell) on a security.
Typically, there are rights and obligations to being an MM. In US stock markets, the biggest benefit is the ability to sell short (i.e. sell a stock without owning it) with few restrictions. The disadvantages are usually some cost (the exchanges often make MMs pay for the privilege) and the obligation always to make a market on a stock, although sometimes the obligation is undemanding enough not to matter.
Depending on how much a MM is needed to maintain a market, exchanges may tweak the rights/obligations balance. In options markets, it is difficult to have enough orders for a security, as there are many combinations of expiration dates and strike prices per stock. Therefore, some options markets (CBOE, PHLX) give extra benefits to a MM as an incentive, the most important being “allocations”: MMs get to trade before, or with a higher quantity than, non-MM firms at the same price level (although retail customers typically get preference over both).
In practice, it is often possible to have a one-sided market (or no market) by entering stub quotes to comply with MM requirements. For example, if GE is trading $25.10 by $25.11, then if a MM publishes a quote of:
  1. $25.10 by $1000, the MM is essentially only buying that stock (or, alternatively, would love to sell at $1000 if anyone shows up at that price).
  2. $0.01 by $1000, the MM may be complying with the letter of its requirements, but effectively declaring no intention to trade.

What does a MM do?

Very roughly speaking, a MM makes a market on multiple securities at a time, and tries to keep its risk neutral (hedged) by making sure it does not have any big individual bet. It may hedge either
  • actively/explicitly: e.g. if at the close of a day a MM is holding $10m of US stocks, it may try to sell $10m worth of S&P 500 futures – or some smaller amount, subject to the risk they are willing to take, because hedging has transaction costs. (*1)
  • passively/implicitly: e.g. if a MM has bought a lot of GE over the course of the day, it may shade/lean its quotes to cause it to sell more than it buys. E.g. if PZZA is trading $50.10 by $50.40, and MM has bought a lot of PZZA, it may have a quote of $50 by $50.40 (so buying at less than the bid price, but selling at the ask price), or post a larger quantity to sell than to buy. Note that this simple example assumes PZZA and GE will both move in the same direction, so it is a gross simplification of a general model where correlations between stocks are utilized.
Buying low and selling high sounds like a slam dunk, but it is not. Aside from the obvious business costs (salaries, offices, computers, compliance, etc.), the biggest enemy is adverse selection. See Marketside chats #1 for more. In short, this is the risk that a MM buys as the price is dropping, or sells as the price is increasing, both of which cause losses. If this had 50-50 chance of going either way, it wouldn’t be worth mentioning, but one is more likely to buy when the price is dropping than when the price is increasing, for various reasons.

Example: my quote is $25.10 by $25.11. I buy at $25.10 when a seller dumps a lot of stock, and then the price drops – the new market is $25.08 by $25.09. Even if I sell at $25.09, I have sold lower than I bought, despite the fact that at every point in time my bid price is lower than the sell price.

Risks that can be hedged

Being properly hedged has obvious risk benefits: it reduces the standard deviation of returns, which is desirable. Less obviously, hedging can also improve returns themselves, as it gives a MM more capital to allocate on doing more market making. The simplest example is being able to quote a larger size (i.e. tell the world it is willing to buy/sell a bigger amount).

A MM cannot be completely hedged, because hedging costs money, either in the form of

  1. trading costs (for active hedging). Simplest example: if a MM buys at $25.10 while the market is $25.10 – $25.11, it could hedge by selling at $25.10 right away, but then it would lose money net of fees and costs.
  2. missed opportunity to market-make more (for passive hedging). After it buys a stock, the MM would stay more hedged if it decided to stop buying more of it, and only have sell orders out. However, it would also miss out on the benefit of buying more on the bid price.
Depending on hedging cost and hedging effectiveness, a MM may decide to hedge more or less.
  • Example #1: if an MM is holding a lot of banks, it may hedge by selling XLF, which is a financial sector ETF. It also includes insurance companies, so not 100% correlated, but it is cheap to trade.
  • Example #2: if a MM is holding a lot of stocks of companies that make their profits outside the US, it may decide to hedge by selling the US dollar, but there is otherwise no security with similar risks that is cheap to trade. It may hedge by selling a similar amount of S&P 500 futures, which are cheap to trade, although not as correlated with the “makes profits abroad” stocks.

Overnight risk is also an issue. US stocks trade from 9:30 AM to 4 PM EST; it is possible to trade during a larger (but not 24-hour) window, but it is much more expensive. Typically, a MM will avoid a large single-stock exposure, but even more so overnight, in the event stock-specific news appears.

In practice, most stock MMs stay hedged by leaning their quotes to buy/sell more, rather than actively hedging. Overnight risk is the exception, as stock futures are cheap to trade, even shortly after the 4 PM stock market close.

Risks that cannot be hedged with securities

There are at least two categories of risk that cannot be hedged in a simple way.

Stuck quotes: a MM may be unable to change its quotes due to some technology problem. If an MM has buy and sell orders on e.g. all S&P 500 stocks, and its network goes down, and there are no other backup mechanisms on autopilot on the exchange side (there usually are), then it would be possible to execute all the buys but none of the sells, if the market drops. When the MM fixes the problem, it may have found out that it accidentally has bought a sizable quantity of every stock it makes markets in.

Other system errors: Without getting into the details, on August 1, 2012, Knight Capital lost $460 million in 45 minutes. Although this is an extreme example, there are many classes of error that can result in losses. It takes a lot of fractions of a penny to make up for them.

(*1) A simple improvement is to use beta-adjusted numbers. For instance, if the $10m portfolio consists of stocks that on average move 1.5x as much as the stock futures a MM is hedging with, the MM will be better hedged by selling $15m of stock futures.