Who Are The Market Makers? What Do They Do? WHY?
Summary We constantly talk about the market makers [MMs] and their activities. It is apparent from their comments, that many readers have varied, limited views about the function of MMs, their status, regulation, objectives, and their compensations. A late-August irregularity in securities markets functioning created knowledgeable analysis and comment discussing all that, much of which may help our perspective and understanding. The August 24 th Market Opening Problem The casual, intermittent user of US equities markets may not even be aware that there was a problem or the seriousness of its condition. By 10:30 am NYC time that Monday, things were pretty much back to near normal, and trading the rest of the day was being conducted about as usual. But the previous hour or two nearly shut down the ability of investors and speculators to carry out their planned transactions. Many unpublicized DK (don’t know) trades complicated the end of day settlement processes. Here is how one deeply involved observer firm described what happened: Recent Volatility in the US Equity Market In late August 2015, the US equity market experienced a rapid spike in volatility as global market sentiment weighed bearishly on stocks. During that period, the VIX volatility index doubled and equity-trading volumes surged as investors reassessed global growth prospects and inflation expectations. Market activity on August 24 was particularly extreme. Before the market opened, global equity markets were down 3% to 5% and the e-mini S&P 500 future was limit down 5% in pre-market trading before wider price curbs went into effect at 9:30 am. Due to these pre-opening factors, the morning began under selling pressure with substantial order imbalances at the open as investors reacting to global macro concerns flooded the marketplace with aggressive orders to sell (that is, orders to sell without any restrictions as to price or time frame such as market and stop-loss sell orders). According to the New York Stock Exchange (NYSE), the volume of market orders on August 24 was four times the number of market orders observed on an average trading day. Extensive use of market and stop-loss orders overwhelmed the immediate supply of liquidity, leading to severe price gaps that triggered numerous LULD (limit-up, limit-down) trading halts. The confluence of these factors contributed to aberrant price swings and volatility across the US equity market. For example, the S&P 500 index was at a low, down 5.3%, within the first five minutes of trading, then rallied 4.7% off the lows before selling off again late in the session to close down 3.9%. Bellwether stocks such as JPMorgan (NYSE: JPM ), Ford (NYSE: F ), and General Electric (NYSE: GE ) saw temporary price declines in excess of 20%. Individual stocks as well as ETPs (exchange traded products) and CEFs (closed end funds) experienced significant dislocations after the opening followed by unusual volatility. Transparency and Information Flow Price transparency and information flow in the US equity market were curtailed from the start, forming one of the key contributors to the day’s events. Anticipating widespread volatility, NYSE invoked Rule 48 prior to the open. NYSE Rule 48 suspends the requirements to make indications regarding a stock’s opening price and to seek approval from exchange floor officials prior to opening a stock. By suspending time-consuming manual procedures, this action should have permitted Designated Market Makers (DMMs) to open stocks more quickly and effectively. However, this rule had the unintended effect of limiting pre-open pricing information in securities, especially for any stocks experiencing delayed opens. Although DMMs actively worked to facilitate a prompt open for all securities, the opening auction was considerably delayed for an extensive number of stocks. At 9:40 am, nearly half of NYSE-listed equities had yet to begin normal trading. These delays, along with the absence of pre-open indications, impeded the normal flow of information, which market makers and other participants rely upon to perform their customary activities with respect to the market open. Without this information, and with many securities experiencing delayed openings, correlations snapped between prices for securities in the same industry or ETPs tracking identical benchmarks deviating significantly from one another. In financials, for example, JPMorgan experienced a sharp decline, while Morgan Stanley (NYSE: MS ) did not. The basis between futures and cash prices for the S&P 500 index also widened considerably – futures traded at a 1.66% discount to the corresponding equity basket. These dislocations heightened uncertainty in the market because the validity of automated pricing models becomes challenged when there are meaningful disparities between the prices of normally correlated securities. Additionally, since many of the computerized processes, which support market making, rely on futures as a reference asset, the ability of market makers to efficiently allocate capital and price risk was inhibited. Market makers faced further uncertainty on the cancellation of potentially “erroneous trades,” adding to their reluctance to trade. The lack of price transparency impaired the ETP “arbitrage mechanism” because market makers were unable to rely upon price information for individual stocks to determine when arbitrage opportunities exist between the ETP and its underlying basket, and to hedge their positions. In the absence of the necessary data, many market makers ceased arbitraging US equity ETPs. Exchange-Traded Products The market forces discussed above led to a temporary breakdown in the arbitrage mechanism of many ETPs. 327 ETPs experienced LULD halts on August 24. Many ETPs also experienced brief periods where they traded at significant discounts to the value of their underlying portfolio holdings. As a result, the events of August 24 left many investors dissatisfied with the prices at which trades were executed and raised concerns about the functioning of markets and ETPs. Further, like individual stocks, the confluence of order imbalances, lack of information flow, and opening issues contributed to differing experiences, even for comparable ETPs. Retail investors who had standing stop-loss orders were especially impacted – once the stop price was reached, the orders were converted into market orders, which were often executed at prices that were markedly lower than the stop price. As stop-loss orders are typically intended to be used to mitigate losses, investor education about the risks of stop-loss orders should be significantly increased. To that end, Figure 1 may be helpful. Figure 1 (click to enlarge) Now You Probably Know More Than You Want And there is even more complexity involved. But the necessary message is that in a trillion dollar a day market complex, lots of actions need to be coordinated. Computer programs that expedite actions have rigidities that need to be softened in some circumstances by human judgment. Often that is where market makers [MMs] get involved. Several of the key MM functions and responsibilities are outlined in Figure 2 Figure 2 (click to enlarge) Source: BlackRock Capital Management Figure 3 identifies the principal roles of MMs as providers of liquidity, the usual MM function thought of when the subject of market makers comes up. Figure 3 (click to enlarge) Source: BlackRock Capital Management Key to understanding these roles are the impact they have on prices and price trends. The size of capital involved in typical transactions is a principal determinant. That makes the first listed category of Liquidity Provider, the block trade facilitating broker-dealer, the most significant stock price impactors of MMs by far. These are irregular but frequently occurring, multimillion-dollar trades. Each one typically has the price impact potential to step away from the posted last trade and the current bid~offer quote by a full percent or more. Skillful execution may prevent such a change, or encourage it. Trade and market savvy are important resources, along with arbitrage experience. Firms engaging in the block trade business are often vertically integrated or diversified in their MM activities into several other or all of the roles listed. Exchange-registered market makers tend to be the traffic cops of the current day exchange world and have procedural influence that affords stature in the internal community. Their exposure to the public is usually quite limited, but their day-in, day-out functions may be essential. The remains of the exchange floor specialist system are here. Wholesale MMs serving regional brokers are essentially an internal function of the MM community and are among the least influential as to procedure or securities prices. Technology dominates the electronic MMs, earning them frequency and pervasiveness of presence in number of trades. The billions of shares regularly traded could not be exchanged without this support. But the typical price changes involved from last trade tends to be tiny and highly mechanistic. Their principal contribution is immediacy of executions at low cost. The high-frequency arbitrageurs or HFT players are the intellectual and market savvy step-outs of the electronic MM organizations. Their influence is in the bid~offer realm more than in the trade volume arena. They are constantly sniffing quotes to find risk-free arb opportunities, and individual investors rarely are aware of their presence. But their reach is extensive and they are a liquidity-providing influence. Competition hones their honesty, as a group. Their accomplishments financially tend to be a basis point at a time, just a million times over. They are expert exploiters of the leverage of time. For those interested in the full complexities of the market making process here is the complete BlackRock discussion and their recommendations for market operating revisions. Some of the underlying problems go back to the 1987 “portfolio insurance” market failure debacle. Conclusion Market makers come in a variety of flavors and perform many functions essential to the power and value of today’s equity markets. Where their influence to the advantage of individual investors is the greatest is in their service to those investment organizations that must trade in market-disrupting units because of their size. That limitation of size is unavoidable since the economic basis for their investing businesses is in the amount of capital under their management. They are active investors in order to utilize their info-gathering intelligence resources. But the advantage for us is that they use the arbitrage skills of trusted market making firms to provide the other side of those big trades and the temporary financial liquidity to acquire or dispose of the thousands of shares regularly involved. In the process of MMs hedging the risk to their capital, what is revealed is the extent of the risk believed to be present. Those self-protective actions and the implicit price-range forecasts prove to be useful guides as to future specific price moves, on a very comparable base among equity investments of wide diversity.
