Friday, September 9, 2011

(ADP) market-makers

"Market-making" is an over-generalized and misused term. Many so-called market-makers publish "indicative" or fake quotes (instead of uncanceled limit orders), or one-way quotes, or wide quotes.

By strict definition, market maker of a security/instrument must maintain firm and tight bid/ask. They take market-risk to create liquidity, so they get compensated somehow. Market making is a job, a responsibility, and a business, just like policing, match making, ..

Say a seller client is asking $300 for IBM, and a buyer client is bidding $100. No deal. A partial sign of poor liquidity (see http://bigblog.tanbin.com/2011/09/liquidity-immediacy-resiliency.html). Market maker now publishes 2 quotes -- asking $200.05 and $199.95 bid. Now the buyer [3] lifts the offer $200.05 + some fees. Now market maker gives in a bit to bid $199.99, as he tries to cover his short position. After some time the seller jumps and sells at that price. Market maker makes a small profit to compensate for the m-risk he assumes.

[3] Note as market takers buyers always get the worse of the 2 quotes i.e. the higher one.

There's a difference between nasdaq market maker vs a NYSE specialist. See http://www.investopedia.com/ask/answers/128.asp

After you understand the basic biz models (http://bigblog.tanbin.com/2010/11/agencyprop-tradersdealer.html), you will realize

* Market-maker is usually a dealer or a prop trader, PnL-based compensation
* when you make a market, you put house/own money at risk -- exactly like prop trading
* Very loosely, a broker role is the "opposite" of market-maker. Most visible in the CBOT trading pit. Brokers take position/risk[1] very very briefly, and trade only upon client orders; market-makers always take positions and _maintain_ bid/offer.
* a dealer often plays market-maker, esp. prevalent in the Treasury/corp/muni market, and IRS/CDS markets, and FX options market and many OTC markets
* MM on a stock exchange? dealers and prop traders. If a broker plays MM, she becomes a prop trader and risks her own money.
* eg: Those locals in the pit could give one-way quotes, so not true market makers

[1] and only when clients default

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http://www.linkedin.com/in/tanbin