Buy? Sell? I do it all
Have you ever thought about why you can buy or sell financial assets in seconds? You don’t waste time finding someone who wants to sell the exact number of Apple shares you need. And if you want to sell a Treasury Bond, you don’t need to post an ad and wait for a buyer—you click a button.
Since modern financial exchanges got their start a few hundred years ago, a role has emerged for “market makers”—once individuals, now firms that buy whatever people want to sell, and sell whatever people want to buy, again, and again, and again. This provides market participants liquidity, or the ability to quickly cash into (or out of) a security.
Market makers profit from the small difference between the cost to buy and the cost to sell, racking up gains by trading constantly, but they have to carefully hedge risk during changes in sentiment and not hold any one asset for too long. Originally the decision-makers were individuals, then partnerships, and then desks at major banks.
But if market-making sounds like something that could be automated, congratulations, you understand the financial industry. Now, software is doing most of the market-making at independent securities firms, and in the brave new world of decentralized finance, even doing it without supervision.
Are you ready to bid, fellow human?
By the digits
$6.3 billion: Average daily value of stocks bought and sold in the US during five days in August 2023
29.1: Average spread, in basis points, between bids to buy stock and offers to sell it on the NYSE during heavy trading in 2019
0.12 seconds: Average execution speed of a stock trade performed for a retail investor by E*TRADE in June 2023
40%: Share of US retail stock trades handled by Citadel Securities, the largest market maker in the US
$4.2 billion: Revenue earned by Citadel Securities in 2022, a record for the firm
ChatNYSE
The rise of robotic market makers
The business of making markets has always been high intensity—consider the classic stock exchange image of men in funny jackets screaming at each other. But the growing number of stocks, and the profits from trading them more quickly than the next firm, has pushed the job toward automation. Finding the right algorithms isn’t so simple, since the real world (and its effects on the markets) is so hard to predict.
High-frequency trading—a strategy that uses computers to arbitrage orders in minutes—has taken on some of the liquidity provision once done by market makers. The approach, however, has been blamed for “flash crashes,” dramatic plunges in market value caused by haywire trading computers.
In the crypto world, meanwhile, proponents of decentralized finance want the market making to be done not just by algorithm, but by algorithms that aren’t controlled by any one institution. Programmers have created automated market makers to do the job, but so far this set-it-and-forget-it model has been slow to adapt to volatile crypto asset prices and susceptible to manipulation.
Quotable
“How do you make a market? Mostly, you type it into a box on your Bloomberg and then hit a button to send it to people. For doing this you are paid a great deal of money. The world is weird, y’know?”
— Matt Levine, Bloomberg financial columnist
Pop quiz
Which of the following is a real market maker firm?
A. Virtu
B. Claire Street Capital
C. Fortress Securities
D. East River Trading (ERT)
The answer to the quiz is at the bottom of the email, and if you got it wrong, our automated service will swap it out for another answer.
Explain it like I’m 5!
Why not a house or a car?
The convenience market makers bring to financial exchanges would be a nice thing to have when you’re making other purchases. And people try: During the pandemic real estate boom, Zillow, OpenDoor, and others launched businesses that would quickly buy houses and try to flip them. But when the Fed hiked interest rates to fight inflation, demand slumped as mortgages became more expensive and the value of homes began to fall.
A financial market maker might have hedged this kind of risk by shorting the houses or dumping them, but you can’t do that with a house—and you have to spend money maintaining it and paying property taxes on it until it sells. And homes, unlike financial assets, aren’t standardized products; it takes time to find the right buyer. Now, Zillow is out of the business, and OpenDoor lost $331 million in the first half of the year. Carvana, an attempt at a similar business with used cars, has also proven to be a money loser.
Brief history
1602: Amsterdam becomes home to the first modern stock exchange, now Euronext.
1792: The famous “Buttonwood Agreement” signed by 24 stock brokers—the market makers of their time—marks the origins of the New York Stock Exchange.
1971: NASDAQ—the National Association of Securities Dealers Automatic Quotation system—becomes the first electronic stock exchange.
2002: Citadel Securities is spun out of Citadel’s quantitative analysis-focused hedge fund to take advantage of new market-making rules.
2005: The SEC issues new rules requiring brokers to make their trades at the venue with the best price, making it easier for banks and trading firms to grow their market-making businesses.
2010: The “flash crash,” when the Dow Jones fell 700 points in a few minutes, is attributed in part to the rise of algorithmic trading, including automated market makers.
2018: Uniswap becomes the first decentralized finance platform to use an automated market maker.
2022: The Securities and Exchange Commission voted on new stock-trading rules that, if implemented, could shift business away from independent market makers and back to exchanges.
Fun fact!
Infamous Ponzi schemer Bernie Madoff was a major advocate of payment-for-order-flow, which juiced the boom in retail stock trading by making it easier to offer no-commission trades to investors; today it is used by brokers like Robinhood and market-makers like Virtu.
Take me down this 🐰 hole!
One of the most famous market-makers is also little known: Jane Street Capital, founded in 2000 by a group of traders and an IBM executive, is one of the leaders in computerized arbitrage. It specialized in keeping Exchange Traded Funds (ETFs) targeted to their indices by buying and selling the underlying securities. But Jane Street is also known for its nerdy culture and affinity for Effective Altruism—many of the managers of FTX, the crypto exchange that collapsed last year, previously worked at Jane Street, including founder Sam Bankman-Fried. Try playing Figgie, a card game invented at Jane Street to simulate trading, to see if you’d fit in.
Poll
Do you ever wonder if it’s become too easy to trade financial assets?
- No, I own a Bloomberg Terminal.
- Yes, whatever happened to long-term investment?
- It’s too easy for OTHER people to trade stock.
Please invest in our risk-free, one-question poll with a guaranteed ROI.
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Today’s email was written by Tim Fernholz, and edited and produced by Annaliese Griffin.
The correct answer to the quiz is A. Virtu, which is a real market maker firm.