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Financial Careers: What is a Market Maker? 2017-04-13T16:45:53+00:00

A Career as a Market Maker

What is a Market MakerA smooth financial system is the lifeblood of global capitalism. But with millions of financial transactions occur every day, maintaining order is no easy task. It is the role of the market maker to help everything function as smoothly as possible.

What is a Market Maker?

A market maker is a registered market participant who commits to buying and selling some quantity of a stock for the public, at a specified price, at all times. Their role is to create a fair, orderly market for a security. Market makers are traders that compete amongst each other for order flow and, in the process, create a more liquid market.

They generally exist in over-the-counter markets and NASDAQ. On listed exchanges, such as the New York Stock Exchange, the role of all the market makers is handled by just one person-the specialist. There are a few major ‘designated’ market makers (DMMs) including BofA Merrill, Barclay’s Capital and Citadel Securities, handling a vast majority of order flow that is traded daily.1 In addition, there are approximately 170 smaller market makers on NASDAQ.2

How a Market Maker Profits

Here is an overly simplified example of a textbook trade for a market maker. Let’s take a security, Pretendo Industries with a market of $45.00- $45.40 (16×25). An order comes into the market maker from a major wirehouse to sell 1000 shares of Pretendo at the market.

The highest current bid to sell the stock in this example is $45. It is the market maker that will take the other side of the trade and buy the stock from the seller. The market maker will either buy the stock that represents an order the market maker is working for a customer or for his own account. Let’s assume the market maker is trading for his own account and buys the stock at $45. Now the market maker, all else equal, is long 1000 shares of the stock.

The market maker no longer wants to buy any Pretendo stock so he takes his own bid way down, to say $44 (there are still other bids at $45 from other market makers). A minute later, the market maker gets a call from another market participant, a major investment bank, that wants to buy 1000 shares of Pretendo at the market. So the market maker sells the stock (he just acquired) to this new seller (the major bank) at the asking price, $45.40. The market maker no longer has any position or “is flat”. For the buy and sell, the market maker pockets $400-not bad for a couple minutes work.

But that was a little too easy. Let’s say the second part of the example, the new buy order from the major bank, doesn’t come in and the market maker is left with the 1000 shares. Some time goes by and no buyers emerge. To entice a buyer to come in, the market maker lowers his offer from $45.40 to $45.35, which changes the inside spread. As a result, this is just what one particular, frugal buyer wanted to see, a slightly cheaper price. Now the buy order comes in and the market maker sells his stock, but at $45.35 since this is the best offer. In this, more likely scenario, the market maker makes $350 on the trade. We say this is more likely because today, market makers have competition from other market makers, as well as ECNs (electronic communication networks) and have to be nimble.

This is an oversimplified example, but it helps you understand the process. The most important takeaway is the customer pays the spread, the market maker gets paid the spread. In reality, the stock above would have to be quite thinly traded to still have spreads that wide.

The most important takeaway is the customer pays the spread, the market maker gets paid the spread.

Criticisms

As facilitators, market makers can go short the market without having to locate and borrow stock, as long as they are engaged in bona fide market making.3 This perk is bestowed in order maintain an orderly market. It’s not supposed to be done in a proprietary manner (for profit) which can sometimes be a gray area.

During the financial crisis, Goldman Sachs market makers were accused of essentially trading against their own clients who lost money on the crash as Goldman made large profits. Goldman traders were forced to defend their actions in testimony before Congress. The traders were exonerated but the reputational hit was unmistakable.

Another criticism usually involves market making during very volatile markets, where market makers have sometimes stepped away from their stock quotes. But how can they do this, since they are obligated to always buy and sell a stock at a certain price? They use what are referred to as “stub quotes”.

Stub quotes are quotes that are so far away from the market, they are meant to be completely token prices. Take our example above.  After buying the original 1000 shares of Pretendo Industries, the market maker drops their bid down to 1 cent, instead of $44. If no orders were coming in and all other market makers did the same, in a panicky market, ‘at the market’ sellers could see one cent prices for their stocks.

This is an extreme example but it has happened. During the flash crash, trades in a few different stocks, including Fortune 500 member Accenture, were executed at this level.4 Others lost over one-third of their value including Dow component Procter & Gamble.5 Without market makers, who stand ready to buy and sell securities at any particular price, there is nothing stopping a stock from losing all of its value in a vacuum if no real buy orders emerge.

Regulators have cracked down on stub quotes since they can be all that remains in a panicked market, especially for DMMs. Also, circuit breakers have been introduced to pause trading in stocks, initially for five minutes while order books can be reevaluated and traders can catch their collective breath. It’s not an ideal situation but it is better than some foreign markets, like China’s markets which remained closed to some market participants for months.

Making Markets in Other Securities

With the advent of decimalization, spreads are razor thin and market makers are forced to take on more proprietary risk. The days of just letting natural order flow come in and making a full point spread are pretty much done-at least in equities.

But don’t cry for market makers just yet. There are many markets that still operate similar to the way the equity markets were a couple decades ago-namely the biggest market in the world, the bond market. Here, we are still in the early innings of automation as bonds are decades behind stocks in being listed and traded on actual exchanges. And considering the global bond market is almost twice the size of equity markets, plenty of opportunity remains.6

But to its credit, fixed income trading has come a long way over the last decade, with the advent of systems including TradeWeb and the larger, MarketAxess, which focuses on corporate bonds and credit default swaps (CDS).7,8

How Much do Market Makers Earn?

The pay for market makers is all over the board and is like saying how much does a salesman make (which depends on how much they sell)? When you start out on a trading desk as an order clerk you basically ‘hit lights’ (answer phones), execute trades and monitor pending orders on a trade management platform, although this is becoming increasingly automated. The pay is pretty minimal, maybe $40k if you’re lucky. But as you gain licenses and experience, become an assistant market maker, the pay can get up around $75k-$100k depending on the desk and firm.

Once you trade your own “list” of securities, the pay gets well into six figures. Market makers typically split the profits with the firm they work for (since the firm provides the trading capital). The percentage varies depending on how good the market maker is and how much the firm needs him. A 70%-30% split in favor of the firm is not uncommon.

How do I Become a Market Maker?

This is the kind of job where it really helps to know someone at a firm to land on the trading desk. Networking is crucial. A bachelor’s degree is typically required and a MBA in Finance can help with the networking side. Although market making is its own animal and what you learn in school doesn’t always prepare you for the intricacies of trading or its stresses.

To actually begin trading for a FINRA broker-dealer you must pass the securities trader qualification exam, known as the Series 57. The focus is less on actual trade strategies and techniques, instead focusing more on maintaining records as well as proper trade reporting.9 As many firms know, failing to adhere to regulations is a compliance officer’s worst nightmare and can cost the firm dearly through fines and penalties.

1,2,7http://www.reuters.com/article/us-financial-regulation-marketmakers-idUSTRE66834R20100709
3https://www.sec.gov/investor/pubs/regsho.htm
4,5https://en.wikipedia.org/wiki/2010_Flash_Crash
6http://finance.zacks.com/bond-market-size-vs-stock-market-size-5863.html
8https://www.marketaxess.com/
9http://www.finra.org/industry/series57

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What is a Market Maker?
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What is a Market Maker?
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A market maker is a registered market participant who commits to buying and selling some quantity of a stock for the public, at a specified price, at all times.
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