Market Making in the New York Stock Exchange
In class, we talked about exchange markets, and traders who connect buyers to sellers. We discussed the societal implications of such a setup, and in what scenarios traders are likely to profit.
In the real world, this process is called “market making” and it is an important part of global financial markets. Large firms fill the role of the “traders” we discussed in class, buying from sellers and selling to buyer
Furthermore, as we discussed in class, such firms profit off of the “bid-ask spread,” or the difference between the price they sell at, and the price they buy at. We mentioned in class that in a market with multiple traders, each trader should be making no profit and social welfare should be optimized.
This would be ideal, but in the real world, market making is an incredibly profitable operation.
One discrepancy comes in the form of the “Designated Market Maker,” which is a firm that is designated to be the market maker for a certain security. If you want to buy or sell a particular stock, then that firm is the firm to go to in order to settle your trade. Not all exchanges use this, but the New York Stock Exchange does!
This inherently creates a monopolistic scenario, as a single firm will have a monopoly over all of the trades happening for a single stock. As we learned in class, this is inherently not a good system, even though market makers are duty-bound to settle trades at the “best prices” for their clients.
Another discrepancy is the existence of “Payment for Order Flow (PFOF),” a system that has come into a lot of media scrutiny lately. PFOF is when a market maker will actually pay a broker a fee in order to settle their transactions. The motivation behind this is to gain even more monopolistic control over market making and to increase the volume of trades settled to increase profit opportunities, and it seems to be working. Citadel Securities is the market-making business of Citadel, a prominent hedge fund. It executes around 47% of all retail (non-institutional) trades in the United States. Citadel also participates in PFOF, paying brokers to execute trades in order to profit further.
All of this has come under the attention of the Securities and Exchange Commission, which has been researching the effects of PFOF and the growing powers of market makers on what should be a fair market.
On the flip side of this, I should discuss some of the economic advantages of market-makers. They are incredibly good at what they do, and can ensure that orders are filled milliseconds after they are placed by a broker. This takes a lot of research, development, and investment. Without a market-maker, it is likely that the highly liquid securities markets would not exist as we know them. The fact that there is a buyer for every seller, and vice versa is a result of these market makers. If there was not any profit available in this business, then it is likely that market making would never exist as seamlessly as it does (the only time anyone really notices Citadel Securities is when they have to write a blog post for a college class!) While these firms are able to profit immensely, the actual impact to the individual trader is negligible, perhaps only a few cents per share: most of this profit comes from the massive volume of shares that are traded daily.
I think the main takeaway from all of this is that while these mathematical models are incredibly insightful and useful, there is a lot of context needed to look at the real world. We can look at the current market making setup and claim that it is inefficient because it is monopolistic and allows firms to profit at our expense. But we can also look at the current market making setup and see that it is incredibly good at routing trades and ensuring orders are placed quickly and efficiently at a very good price. There really isn’t a right answer here.
With all of this said, I don’t mean to claim that the system is fair or unfair. That question is far above my pay grade. Except I don’t get paid. If I’m actually able to get a job at Citadel in a few years, I’ll be happy to answer though! 🙂
Sources:
https://www.marketwatch.com/story/sec-chief-warns-of-growing-monopoly-power-among-market-makers-retail-brokers-at-gamestop-hearing-11620323045
https://www.citadelsecurities.com/products/equities-and-options/
https://www.nyse.com/markets/nyse/membership
https://www.investopedia.com/terms/p/paymentoforderflow.asp
https://www.investopedia.com/terms/d/designated-market-maker-dmm.asp