(I'm going to agree with your first sentence by disagreeing with everything you said about market making)
> Look at market making (providing liquidity for other traders). There's an intrinsic demand for liquidity from funds which try to manage an index, hedgers, and speculators. The goal of market making is to provide liquidity to facilitate those other traders. And yes, there's a small premium for the service, but the fact that the premium is shrinking over time reflects a lower cost for the rest of society.
I think that's a very quaint view of market makers, maybe valid 20 years ago but it seems disconnected from modern circumstances. Market making has largely become synonymous with algorithmic trading, which now accounts for somewhere between 25%-75% of traded volume (obviously varying widely between markets, see http://ftalphaville.ft.com/blog/2011/03/04/505021/algo-tradi...).
A significant subset of the prop traders have been spiraling into a latency arms race, which has gotten to this absurd point where even millisecond-scale trading is considered slow.
Regular old market making (put orders on both sides of the book, make profits from the spread) only seems to work in the absence of significant competition. In reality, profitable firms are running all sorts of short-term speculations and even trying to prey on the trading behavior of people & other algorithms. There have been all sorts of algo-induced pricing anomalies documented at http://www.nanex.net/FlashCrash/FlashCrashAnalysis.html.
The supposed benefit of all this nuttiness is improved liquidity, but I wonder: Who needs liquidity at the millisecond scale? What business, other than algorithmic speculation, will suffer if they have to wait 1/2 a second to buy or sell something?
Also, I question whether the premium of modern prop trading is actually small-- there are a large number of prop trading firms that seem to be doing extremely well for themselves. I don't know the specifics, but I wouldn't be surprised if the sum of prop trading profits reach high into the billions.
Furthermore, these companies siphon off a large number of smart grad students, who would have likely otherwise done something actually socially productive with their time.
A lot of people support "market making", but then talk about frontrunning trades in situations that are morally and technically equivalent to market making. Computer nerds tend to assume the role of "market maker" is more formally defined than it really is. Really, there are just liquidity sellers and liquidity buyers.
The upshot of this argument is that this is valuable activity. We need markets to price tradable assets and provide liquidity.
The counterargument is that there are diminishing and/or negative returns to increased liquidity and velocity.
Take just stocks. Liquidity is not a problem. You have liquidity whether trades take minutes or milliseconds. Pricing? I'd say we have pricing covered too, at least the pricing that more/faster algorithmic trading will contribute.
Meanwhile, all this stuff costs money, people, resources that aren't available for actual productive work instead of overhead.
Ah okay thanks. I always just considered professional market makers (as described there) as just another kind of participant or counter-party who just has a particular strategy and maybe takes advantage of volume rebates or similar (but basically transparent) incentives to act as a liquidity provider.
But I see that you're making a comparison about bitcoin markets where that kind of structure is mostly not there.
That reminds me. For anyone interested, there's an interview with a HFT market-making guy here who set up the LXDX exchange for crypto derivatives and who talks a bit about the differences in market microstructure: https://www.youtube.com/watch?v=xkhLZXLb8mU
You are partially right. What you miss is that there are the so called market makers - exchanges that ensure liquidity. They buy from you and sell to you while managing order books. These are simply trades records that have a key role in determining the price pressures for it go up or down.
The claim that market makers pass costs on to end users is only true if they have pricing power. In reality, on-exchange liquidity provision is basically the kind of perfect competition that only exists in economics textbooks. Market makers are selling a commodity product (you don't care or control who you trade stocks with) in a market where buyers are purely sensitive to price (tightest market always wins and is enforced by exchange matching rules).
So what actually ends up happening in a market with multiple competitive market makers? To make money, a market maker needs to trade a lot of volume. The only way to trade a lot of volume is to put up the most aggressive (worse for the market maker, better for end users) prices at any time. Market makers can only do this by charging a smaller spread than their competitors. They can only charge a smaller spread by either reducing their margins or getting smarter at deciding when to be in or out of the market, usually a combination of both. The end result is extremely tight markets that react to information very quickly (i.e. cheap to trade and very efficient).
Competition keeps markets honest. If you had one very fast guy, he would clean up, but when you have a dozen guys who are roughly equally fast, they all compete one another down to barely making profit above their cost of doing business. Only the most efficient can survive. If anything, we want more HFT by removing barriers to entry rather than creating a lot of regulations that would ironically help incumbents by killing off weaker competitors.
>Spread trading (or "market making") is also misunderstood. People see market makers as scalpers when in fact they're providing a valuable service: they're creating liquidity. The reason you can buy or sell shares at any time (rather than waiting for a seller or buyer to show up) is because of market makers.
Except market makers generally target markets which are already highly liquid, so I would guess most of them aren't providing a tangible service to anyone working at human timescales. I remember reading that Chi-X had only 1 (!) high frequency market maker for the first 1.5 years they were open and liquidity there was just fine.
There's not a market maker in America that's selling and buying in order to provide liquidity.
You buy low, and sell high, that's the end of the story, for both proprietary trading, trading for clients, and market making. There's no fundamental, categorical difference between these functions.
The difference between prop trading and market making is fundamentally about the time horizon of exposure. Market makers are aiming to zero out their exposure through frequent trading, while prop trading attempts to express a view on the market in the long-term (seconds for market making vs minutes/day/years for prop trading).
I'm a professional quant, and I don't see much of difference, at least as far as the government is concerned.
Well - ok - I may have overstated in that: Yes, market making provides more liquidity. Yes, it makes it more efficient. Yes, for everyone, not just the marketmakers and exchanges.
But no, this is not the reason marketmakers make markets.
They do this in order to make more profit.
The rest is a side effect that they happily spindoctor into their "raison d'etre".
The company I worked for is known for being the primary source of rich people in the Netherlands. And they keep getting richer. Very much the so-called 1%.
The whole business model is misunderstood by your average internet commentator.
When you have a market, you need someone to be there to provide liquidity. Imagine if you're a farmer and you show up to the market with your wheat, but all the bakers have gone home that day. Or the baker shows up and there's no farmer. The market maker stands around all day offering to buy and sell so that you don't have to wait for the guy you're really trading with. Of course this middle man wants to get paid for it, but your cost as an average Joe is next to nothing. This is trading in time.
Now imagine you want to cook a meal and your ideal meat is beef, but actually you're ok with pork, so long as the pork is cheap enough to make it worth it. How much cheaper should it be? Well your fellow who knows all the pork and beef people will be able to gauge where the balancing spread is, given the amount of interest. In fact he will from time to time do the trade when the spread is out of line. This is trading in space.
So why all the fancy tech? After all market makers used to stand around in a pit in a colored jacket, and they didn't have degrees. My first boss in the market was one of these guys.
Well, things have gotten very tech heavy because as soon as prices are out of line, there is money to be made. Or rather, lost. As a market maker, you are constantly out there with your prices, offering to buy or sell at a very small spread. If some news happens that affects prices in a big way, you can be sure that you will buy when it's going down and sell when it's going up. In order to both have tight prices and avoid this "adverse selection", you really want to be able to react as quickly as you can when your system decides that something's up.
> Market-making also delivers real social utility. The deeper the liquidity provided by market makers, the more difficult it is to cause erratic spikes in price. Market makers also reduce the bid-ask spread, a concept most people aren’t even aware of: a testament to successful practitioners on Wall Street.
Until they don't. The moment people need liquidity the most is the moment the market makers have pulled all their orders and the market is in free-fall.
The market makers do understand why they are trading and understand it has nothing to do with fundamental value. That may be your reason for trading. They are there to rapidly and correctly assess short term supply and demand so they can extract compensation for providing liquidity. And that’s a good thing. A market made of heterogenous actors with different objectives and time scales is far more robust.
"I am conjecturing that there are minimal benefits to an exchange to having more than one Market maker at a given stock within a given price range."
Could you perhaps explain the downside of having multiple market makers per stock? It seems trivial to state that competition in providing liquidity alters the cost of said liquidity and disprove your contention - but why bother to make that argument when there can't really be additional costs by multiple parties competing to offer a service?
Market makers provide cheap liquidity. Or in other words, compare the total transaction costs (bid-ask spread + commission) you would to pay today to trade 100 shares of stock today vs 30 years ago. The difference is staggering.
Many of these firms are market makers. That’s a role that has existed in markets well into the 19th century. Market makers are contractually obliged to offer a price for any security on their books. That means if you want to sell, you always can no matter what is happening in the market (unless it’s suspended). Nowadays all market makers (that I know of) trade algorithmically and given that volumes and speeds at which modern markets operate, it’s pretty much the only way they could without having to charge considerably higher market maker fees, increasing costs for everybody.
Furthermore, if I want to sell a security and one of these companies puts in the best bid, then I just made more money than I otherwise would have if they weren’t there. Likewise if I was buying, they might offer me a lower price. Isn’t that a good thing? They are happy and the counterparty is happy.
Then there’s arbitrage. If I am trading on an exchange, but there’s a better price on another axchange one of these firms trades on, they might offer me a better price than I otherwise get. Effectively I d get a price on the other market, without having the costs of trading on it. Again, that’s better for me, where ‘me’ might be your savings account or pension fund manager, or a manufacturer or producer on a commodities market. So these firms reduce costs for other participants on the market.
You don't understand market structure. Market making provides liquidity which is literally required to have efficient markets. I don't know enough about how his bot operates but if he is a maker of liquidity then he is providing a useful function. Please don't spread FUD and fake news if you don't understand market microstructure.
The main point that you're missing is that there is a huge demand for liquidity during a majority of market hours. On average, 7 billion shares of US equities are traded every day. That is a monumentally large number if you think about it. According to the TABB consulting group, roughly 50-70% of American stock trades are done by HFT [1]. Let's assume that 10-20% of trading is non-profit motivated (utilitarian, you could say). That means that roughly 1 billion shares are exchanged every day by utilitarian traders. That in itself should be clear evidence that there is a large demand for liquidity.
HFT market makers play an important role in those transactions. Specifically, they make it cheaper to buy and sell stocks by (1) tightening the bid-ask spread and (2) providing more quantity at each price, so that the average cost of executing an order is less. Not only that, when markets become tighter, they actually enable transactions to occur that would not have happened before. In other words, previously where buyers and sellers would NOT have traded because the transaction costs of crossing the bid-ask spread were too high, those two parties can now trade. Specifically, without HFT, there would be far fewer than 1 billion shares traded by utilitarian traders on a daily basis.
To address the other point of providing liquidity "when the markets need it most", let's take a step back. When you say that "market makers should step in to provide liquidity [for society's benefit]", you're implying that there's some externality to lack of liquidity in financial markets (if so, this is yet another reason that we need HFT on a daily basis). Suppose that this is the case: there is some negative externality to society when markets are illiquid, as is oft to happen when things go crazy in the world. During those times, volatility is insanely high because the risk of being in any position is also insanely high. Remember, market makers get compensated (on average) for holding risk that you don't want. If risk is higher, naturally, the compensation should be also. This is manifested in higher costs of execution: spreads widen and the available quantity at each level decreases.
If you want to force HFT market makers, which are private corporations, to step in to provide more liquidity, then you are forcing these companies to pay for that externality. In effect, they would take on huge risk for far diminished expected returns. That doesn't make any particular sense to me. However, if society as a whole has this view that some private corporations need to pay for public externalities, then that should be a matter of regulation. But if that's the case, why pick on HFT in particular? Why not force McDonalds and Whole Foods to give food to hungry people during famines? Surely, there is an externality to the food industry NOT stepping in during periods of extended hunger, "just when people need it the most."
Market making you provide a buy and a sell price and keep the spread for your "service".
Prop trading: you buy or sell based on a guess which way things will go and hold that position then exit at (you hope) a profit.
Normally the big book of banking says market makers "provide liquidity" which in my experience is enough to make most people in banking stop right there as providing liquidity is to them akin to passing bread to orphans.
That's not true. An extra market maker provides the benefit of competing market makers, which should reduce the spread.
Most markets are not specialist markets. Specialists at the NYSE were accused of skimming hundreds of millions of dollars from customers. They're an anachronism and a much more disquieting idea than robots competing to provide the best price --- which is pretty much what most HFT systems do.
> Look at market making (providing liquidity for other traders). There's an intrinsic demand for liquidity from funds which try to manage an index, hedgers, and speculators. The goal of market making is to provide liquidity to facilitate those other traders. And yes, there's a small premium for the service, but the fact that the premium is shrinking over time reflects a lower cost for the rest of society.
I think that's a very quaint view of market makers, maybe valid 20 years ago but it seems disconnected from modern circumstances. Market making has largely become synonymous with algorithmic trading, which now accounts for somewhere between 25%-75% of traded volume (obviously varying widely between markets, see http://ftalphaville.ft.com/blog/2011/03/04/505021/algo-tradi...).
A significant subset of the prop traders have been spiraling into a latency arms race, which has gotten to this absurd point where even millisecond-scale trading is considered slow.
Regular old market making (put orders on both sides of the book, make profits from the spread) only seems to work in the absence of significant competition. In reality, profitable firms are running all sorts of short-term speculations and even trying to prey on the trading behavior of people & other algorithms. There have been all sorts of algo-induced pricing anomalies documented at http://www.nanex.net/FlashCrash/FlashCrashAnalysis.html.
The supposed benefit of all this nuttiness is improved liquidity, but I wonder: Who needs liquidity at the millisecond scale? What business, other than algorithmic speculation, will suffer if they have to wait 1/2 a second to buy or sell something?
Also, I question whether the premium of modern prop trading is actually small-- there are a large number of prop trading firms that seem to be doing extremely well for themselves. I don't know the specifics, but I wouldn't be surprised if the sum of prop trading profits reach high into the billions.
Furthermore, these companies siphon off a large number of smart grad students, who would have likely otherwise done something actually socially productive with their time.
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