Why are Market Makers necessary?

[Fuzzy_Dunlop]

@mswas

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 investopedia.com

@Investopedia.com

What Does Electronic Communication Network - ECN Mean?
An electronic system that attempts to eliminate the role of a third party in the execution of orders entered by an exchange market maker or an over-the-counter market maker, and permits such orders to be entirely or partly executed.

[mswas]

@Fuzzy_Dunlop

From investopedia.com

[QUOTEInvestopedia.com]
What Does Electronic Communication Network - ECN Mean?
An electronic system that attempts to eliminate the role of a third party in the execution of orders entered by an exchange market maker or an over-the-counter market maker, and permits such orders to be entirely or partly executed.

[/QUOTE]

Ok, I understand what it is, I just wasn’t parsing the acronym at that moment for some reason.

[Trom]

I trade professionally at a trading firm. Most of what people think about market makers is from the NASDAQ bubble period and not at all applicable to the modern equity market. There is intense competition to make markets in most stocks. Most of it is automated, as well. Only in special situations will market makers turn off the autopilot. In most stocks, due to the competition from proprietary and high frequency trading firms, market makers are a non-factor. When looking at more illiquid and less frequently traded stocks, market makers serve more of a function. When there exists an unusual demand for liquidity, such as during an index rebalancing period, market makers (official or otherwise) are very useful.

An example:

On 12/18/09 a few different indexes rebalanced (dropped one company, added another). When this happens, all index funds that attempt to track an index need to adjust their holdings accordingly. Look at ticker symbol BCAR. In the last ten minutes of trading there were orders to buy ~400,000 shares of stock. On a normal day BCAR trades ~10,000 shares. For whatever reason, there were no active market makers in this name. As a result, the stock traded up to $8.70, where supply equaled demand. The stock was a $4.00 stock five minutes earlier. Nothing changed fundamentally with the company, it was just everyone trying to get in at the same time. It is now drifting back down to its fair value. If there had a been an active market being made, that dislocation wouldn’t have happened. Due to the absence of market makers, index mutual fund holders got screwed.

[mswas]

@Trom

I trade professionally at a trading firm. Most of what people think about market makers is from the NASDAQ bubble period and not at all applicable to the modern equity market. There is intense competition to make markets in most stocks. Most of it is automated, as well. Only in special situations will market makers turn off the autopilot. In most stocks, due to the competition from proprietary and high frequency trading firms, market makers are a non-factor. When looking at more illiquid and less frequently traded stocks, market makers serve more of a function. When there exists an unusual demand for liquidity, such as during an index rebalancing period, market makers (official or otherwise) are very useful.

An example:

On 12/18/09 a few different indexes rebalanced (dropped one company, added another). When this happens, all index funds that attempt to track an index need to adjust their holdings accordingly. Look at ticker symbol BCAR. In the last ten minutes of trading there were orders to buy ~400,000 shares of stock. On a normal day BCAR trades ~10,000 shares. For whatever reason, there were no active market makers in this name. As a result, the stock traded up to $8.70, where supply equaled demand. The stock was a $4.00 stock five minutes earlier. Nothing changed fundamentally with the company, it was just everyone trying to get in at the same time. It is now drifting back down to its fair value. If there had a been an active market being made, that dislocation wouldn’t have happened. Due to the absence of market makers, index mutual fund holders got screwed.

And so why is it important to shield these mutual fund holders from getting screwed? I mean I understand why they would not want to get screwed but from a larger societal perspective. Also, if they are not in the process of selling how does the blip affect them? What if they were golfing in Fiji all day and they sold nothing? How did they get screwed?

[Trom]

@mswas

And so why is it important to shield these mutual fund holders from getting screwed? I mean I understand why they would not want to get screwed but from a larger societal perspective. Also, if they are not in the process of selling how does the blip affect them? What if they were golfing in Fiji all day and they sold nothing? How did they get screwed?

Due to an index rebalancing (probably the Russell 2000) funds HAD to buy BCAR on Friday. Because there was no liquidity, now a lot of funds own BCAR from a price of $8.70. They were basically forced to buy the stock 100% too high. Now it will take a ~100% up move in the stock in order for the funds to break even on the position. That will create a distortion in the “real” return of the Russell index. If the stock closes next year at $6.00, that would be up 50% from where it was trading prior to the rebalancing. But, because of the illiquidity during rebalancing and the temporary price spike, the Russell index will calculate the BCAR component as a ~30% loss.

I’m not sure what you’re asking about selling and Fiji… the people that sold BCAR at $8.70 made out like bandits. They essentially had the market cornered and were able to sell for a 100% gain in 10 minutes. The people that got screwed were the NEW shareholders in BCAR.

[China_Guy]

MSWAS, I think you’re missing one key point. (someone correct me if this has changed in the last decade).

MM make the spread or the quoted market and that’s where they make their money (and not from higher fees).

For exampleM stocks are quoted at a 5¢ spread. Stock A is quoted at $1.00 - 1.05. in other words, for you as a buyer you pay $1.05 for one share or can sell a share for $1.00. Eg, you get the worst price buying or selling. The MM is the one that gets the best price (they sell for $1.05 and buy for $1.00.) The MM does not drive up the price, rather they are allowed to take advantage of the spread in return for making the market.

[mswas]

@China_Guy

MSWAS, I think you’re missing one key point. (someone correct me if this has changed in the last decade).

MM make the spread or the quoted market and that’s where they make their money (and not from higher fees).

For exampleM stocks are quoted at a 5¢ spread. Stock A is quoted at $1.00 - 1.05. in other words, for you as a buyer you pay $1.05 for one share or can sell a share for $1.00. Eg, you get the worst price buying or selling. The MM is the one that gets the best price (they sell for $1.05 and buy for $1.00.) The MM does not drive up the price, rather they are allowed to take advantage of the spread in return for making the market.

The way I understood it was that by taking advantage of that spread the price goes up. Because if I buy it at 1.05 I want to sell it above 1.05. So when they sell it to me, is it measured as being a sale at 1.00 or is it measured as 1.05?

[China_Guy]

@mswas

The way I understood it was that by taking advantage of that spread the price goes up. Because if I buy it at 1.05 I want to sell it above 1.05. So when they sell it to me, is it measured as being a sale at 1.00 or is it measured as 1.05?

let me clarify. The price is always quoted as the last traded price. Eg, at 1.05.

The spread would look something like: the bid is 10M shares at $1.00, and the offer is 5M shares at $1.05. The spread would not “really” move up to 1.05 1.10 until all 5M shares at 1.05 are traded (lifted) if it is a liquid stock. The MM is under no obligation (IIRC) to trade either side because there are bids and offers. If there are no bids (or bids but not offers), then the MM would need to take the other side of the trade.

bid
.9 = 1M shares
.95 = 2m shares
1.00 = 10M shares

offer
1.05 = 5M shares
1.10 = 10M shares
1.15 = 15M shares

[Trom]

Keep in mind that you as a retail investor can provide a bid/offer that creates a new “inside” market, too. If a market maker is quoting $1.00 x $1.05, you could bid $1.01 and jump in front of the market maker’s bid.