Why are Market Makers necessary?

Why can this position not be automated? Why is it necessary to give a small group of people the keys to the kingdom in order to build liquidity when software platforms that can connect the buyer to the seller directly and maintain lists of buy and sell positions without the necessity of a middle-man?

I’ve been out of the biz 10+ years…

Market makers are definitely an anachronism in developed liquid markets. In the old pre-internet days, MM tended to have a good ‘pulse’ on whatever they traded, were willing to take on positions given they wide spreads they had. MM were quite influential as if there was one sided demand, and if the MM wouldn’t step up, the rest of the pit tended to follow the MM lead.

for example, a big sell order comes thru on company X. The MM would judge who is selling (an above the board broker, a spiv, a known front runner,ect), weigh that against the MM Knowledge of company X (usually the MM knew his shit), pulse on the market, etc., and then decided whether or not to take the other side of the trade.

At Swiss Bank Corp, I supported the Hong Kong futures MM for the first several months when the exchange started up the hang seng index futures and volume was really thin. Now it’s an extremely mature market and may not even have MM any more.

I was glued to bloomberg, reuters, reporters, etc and fed the MM real time updates of all ‘news’ and expected impact on trading. for example, unsubstantiated reports of a riot in china when the market was jittery would have a different effect versus in the middle of a bull run.

not sure if that answers your question. I’m curious myself if MM are still in the biz or needed.

Because the Market Maker keeps a supply of stock as a reserve.

Say you want to buy 100 shares of the Blue Sky Corp (BSC). You look for a seller. But BSG is a hot stock, and no one is selling. So it might take time for your order to go through.

Enter the market maker. He has thousands of shares of BSC. He sells you 100 of them. Your transaction takes place quickly.

Now say BSC is dropping like a rock. You need to sell your stock now or you’re ruined. But no one is buying. Enter the market maker. He’ll buy your stock for his reserve (he’s required to). Without a market maker, the stock you want to sell at 30 – the price when you want to sell it – won’t sell for that price. Maybe it sells at 20. In the meantime, you’ve lost thousands of dollars.

Since computers can’t own stock, they can’t use their reserve to keep the transactions going through when buyers can’t be matched to sellers.

Wait, are you trying to say that somehow non-MM investors as a whole save money by having market makers? Wow, how generous of the MMs to buy stock for more than they think they’ll sell if for, just to benefit the little investor. :rolleyes:

In case my sarcasm wasn’t clear, other investors don’t get more money because of MMs. In fact, MMs have to be making money off of the rest of us, or else they’d go broke or quit. In your little scenario, the MM won’t buy the crashing stock for 30 either; he won’t buy it for more than he can sell it for. The MM might make a guess as to where the stock will end up and offer a little less, but that’s just what every other speculator is doing, and if everybody thinks the stock is really worth 20, then that’s what the MM will offer, too (in fact, he’ll offer 19. He has to get his cut, you know). It’s just that the MM will offer 19 a little sooner.

Computers can’t own stock, but the bank or other institution owning the computer can. As it is now, the human being in the equation is usually an employee of the bank or brokerage which is the market maker. The question is whether you can replace that human employee with an automated system - somebody or something has to do the mediation and provide reserves. There would still have to be a way for the MM institution operating that system to make money, and it might very well still be via spreads on bid / ask prices. They would just be managed by the automated system, rather than a human. I’m somewhat skeptical. For one thing, if the mediation system is too deterministic, you are just encouraging a lot of sharpies to attempt to game it.

If your stock is dropping and you want to unload it at 30 and there are no buyers as people wait for it to fall to 20, you’re damn right the investors save money. If the last sale is 30, the market maker has to buy it at close to that price. He can’t wait for it to drop; he has to buy is as soon as its offered.

No, the market maker is required to buy the stock at the most recent sale price (within certain wiggle room – a dollar at most), even if he loses money on the deal. That’s part of the deal for being a market maker: you do make money on transactions, but you also stand to lose your shirt if the stock tanks. The purpose of making a market is to ensure that if the investor wants to sell or buy a stock now, they can get that stock now, and not when the price drops.

My Series 7 teacher told the story of a time when everyone knew that the market was going to drop at the opening bell, and they there were no buyers, and how the market makers (actually specialists) hid in the men’s room so they wouldn’t lose their shirts and only came out when the head of the exchange told them they’d lose their rights to the floor of the exchange if they weren’t out there on time.

But if you make a market (or are a specialist on the NYSE), it means you have to buy any stock that doesn’t have a buyer, at the last sale price (again, there’s a tiny bit of leeway).

Even if the stock isn’t dropping, the market maker lets you buy or sell when there is no corresponding buyer or seller. You want to unload 50,000 shares of a stock? If only 30,000 shares are required by buyers at that time, there’s 20,000 you can’t sell. The market maker will make sure you can sell the entire 50,000 even if there are no buyers right now. The same if you want to buy the stock.

As for automating it, it offers no real advantage (I wouldn’t be a bit surprised if there was some sort of automating, though, NASDAQ is computerized, of course). And the market makers will still have to own the stock to keep the market running smoothly – and will want fees for their work (and the offset the very real possibility of loss). So, essentially, the system you advocate is no different from the way things are done and offers no advantages to anyone.

I’m sure you realize this RealityChuck, but just to point it out explicitly - that’s not only the purpose of making a market it’s also the definition of making a market. If someone were behaving like Quercus conjectured, they wouldn’t merely be breaking some rule, they’d literally not be making a market purely in terms of definition.

Why is it important that a person be able to sell their stock? If there are no buyers why have a market maker there to buy a stock no one wants?

And also, why not have a real-time trading platform? Not a brokerage, but like a search algorithm that connects end users for some kind of fee? The transaction, and what it’s for being irrelevant to the software hosting company.

They maintain liquidity which substantially lowers transaction costs which is very important. If you’re not interested in liquidity why even have an exchange? All sales could be private placements costing tens of thousands of dollars in legal fees, like with a start-up firm doing a round with a VC.

Market makers are a real-time trading platform. They connect buyers and sellers (end users) for a specific kind of a fee (their turn). You seem to be thinking of a market maker as a guy who works on Wall Street and spends his days making a market for a particular security. That’s true and fine but that guy is also going to be working for a firm like LaBranche & Co that’s also a market maker. If they fired all their finance guys and hired computer engineers to manage their software solution they’d still be a market maker and they’d still be making money on the bid/offer spread.

Things are moving toward your idea anyway, for instance with foreign exchange markets. I just don’t think it’s as big a difference as you believe it is conceptually.

I read the title of this thread as "why are magic markers necessary… that would have been a horse of a totally different color.

Thanks for this thread. It’s something I’ve always been a little iffy on and really appreciate the clarity. Thanks!

This is a bit of a straw man. You are saying it must be this way because that’s the problem market makers were created to solve, pre information age. But why is that necessary now? Why must the only options be expensive transaction costs or market maker? I’ve been getting this a bit in other discussions. The general assumption is that certain legal arrangements are like objective realities when the legal arrangements can be changed. If we wanted to, we could make it legal to trade stocks in real time digitally with the buyers and sellers interacting directly rather than selling to and buying from the market maker. So if I can only sell 30,000 shares I can only sell 30,000 shares. The other 20,000 will have to wait for a buyer.

I’m just trying to figure out why the liquidity they provide is necessary, and the answer always seems to be, “Because that’s the way the law is setup.”, so why can’t simply change the law?

Well what I was referring to is a market facillitation platform. The company wouldn’t exactly be market makers in that they wouldn’t be injecting liquidity into the market. All they would be doing is facillitating buys and sells, the transactions for which can take place between the banks of the buyer and seller. More like an introduction service than a market maker, as the company that runs the software never purchases the stock.

I don’t buy/sell stocks, so my opinion is pretty casual. However, what the OP is saying certainly could be done-a computerized trading system without a MM. If it is large, it might even be cheaper to operate than the existing markets. But consider, if you are someone who wants to buy/sell a stock and have two choices: 1) the existing markets with MM where your 50,000 shares will be sold at a known (close to) price, or 2) a new market where you can only sell 30,000 of your 50,000 shares at all-until someone came along and offered much less for the remaining stock. Which market would you choose? The existing markets work because they are better for buyers and sellers in some cases. If you have 50,000 shares of IBM and want to sell in a market where millions of IBM shares trade every day then the OP idea might be cheaper. But getting to the millions of shares every day in the face of existing markets is the trick. I don’t think the law has that much to do with it. If traders can make more $ by changing the law, I suspect they would turn the lobbyists loose in a heartbeat.

Well these guys are the central traders. The house that rigs the game so to speak. These are the guys that cash in your chips basically. :wink:

So if they have to buy stock at a price greater than what the market is willing to pay, and sell stock at a price less than what the market is willing to accept, how high are the fees to make them not lose their shirts?

Most of the time they are buying stocks at the average price it sells at, and they can increase the price by a nominal fraction. So your stock you sold them for 50.05 is sold by them for 50.10, and that’s partially where the growth in stock price comes from. They do this one a large volume of transactions. So they make high vol low margin trades. They only get stuck holding the bag if there is some sort of break in the market where someone doesn’t want that stock but someone else wants to sell it.

Speaking of straw men, I didn’t say anything at all about legal arrangements of market makers being a reason to maintain the status quo. The only thing I said about legality at all was that private placements are an expensive alternative to a highly liquid stock market due largely to transaction costs (i.e. legal fees).

Are you familiar with ECNs? Do they differ tremendously from what you’re arguing for? I don’t see how, unless I’ve misunderstood your point. I just don’t see how they’re fundamentally from an economic point of view.

Are you trying to figure out why the liquidity they provide is necessary or why it’s necessary that they provide the liquidity? It’s not so important that market makers provide liquidity, it’s just important to have liquid markets.

Again, I’m not clear how this differs from an ECN. I’m also not clear why it’s fundamentally better or different from a market maker on an exchange in your mind.

Really I am asking this question because I am just learning what a Market Maker is, so I am just challenging the idea to see if I understand it. What’s an ECN?

from this interesting article

Given that you’ve not exactly covered yourself in glory here, this may not have been a wise idea. You still don’t seem to understand the value of liquidity, and that a Market Maker, regardless of what the Maker is, does add that.

I understand what the market maker does.

And I’ll leave covering oneself in glory for the smallfolk who care about such things.

I’m in the business of trying to come to a better understanding of the topic here in GQ, not impressing the smallfolk.