Know Your Counterparty: Ethics and Market Making
--
Learn exactly how market makers generate profit and about a possible ethical dilemma.
Market Makers, you’re told they’re your trading counterparty and are predatorily on the other end of every trade you make. Well, not really. Also, kind of. Allow me to explain just exactly how MMs trade and generate profit and how it affects you.
Let’s start with a scenario. Client A at an investment bank wants to buy 100,000 shares of Stock A. The current quote of stock A is “Bid: 20.00 Ask: 20.02”. The market maker for client A does one of three things:
A. Matching against inventory
Most market-making firms often have an inventory of stock for hundreds of tickers. In this scenario, we assume the MM for this stock has an inventory of 100,000 shares at an average price of 20.005 already. The firm can now unload its inventory onto the client for the price of 20.01. The client realizes an improved order price as opposed to the market ask of 20.02 and the market maker realizes a $500 profit. ($0.005 x 100,000)
B. Arbitrage
Let’s assume that the market maker does not already have an inventory of stock A. The market maker will sell to the client at 20.02 instantly, and the client realizes an instant fill, bypassing the order queue. Now the market maker is short 100,000 shares. The market maker can now do three things: wait for a client that wants to sell their stock A, hedge their exposure, or improve the order book by placing a bid at 20.01 hence tightening the bid-ask spread. Assume the market maker chooses to improve the order book’s liquidity and receives a fill, the MM would then realize a profit of $1000 (.01 * 100,000).
C. Both A and B
Finally, the market maker can trade a combination of the possibilities. Assume the MM already has an inventory of 80,000 shares at an average price of 20.00. The MM will now sell 100,000 shares to the client at a price of 20.02 and instantly buy the extra 20,000 shares from the next ask at 20.03. This brings the average cost basis down to 20.014, resulting in a net profit of $600 (.006 * 100,000).
Ethical Concerns
Now that you’ve seen how market makers generate their profit, let’s examine a…
