It Pays to be a Market Maker!
The importance of market makers in the financial markets cannot be understated. Exchanges like the New York Stock Exchange, Nasdaq, and Chicago Board Options Exchange provide liquidity to the market, facilitating millions of transactions per day between buyers and sellers of various financial securities. In this blog post, we’ll look deeper into market makers and how they generate revenue through the trading network.
As seen from lecture, market makers (T1 and T2 below) are intermediaries between buyers and sellers in the trading network. To facilitate a transaction, market makers purchase a security from a seller at a bid price and then sell the same security to a buyer at an ask price. The difference between the bid and ask prices, or the bid-ask spread, determines the profit the market maker realizes through a transaction.
Placing multiple market makers in the trading network encourages them to compete against each other to fill buy and sell orders. In the graph above, we can see that both T1 and T2 seek to connect buyer B and seller S. Naturally, T1 and T2 both offer more competitive bid-ask prices in an attempt to outbid each other until both their bid and ask prices converge to 1/2. This is an example of perfect competition, or equilibrium, where the market makers realize no profit for facilitating transactions.
However, this begs the question: does perfect competition usually exist in the markets?
Simply put, the answer is no!
We know this to be true because market-making firms are incredibly profitable. According to the Quartz article below, Citadel Securities and Virtu Financial, two market-making firms that control roughly 22% of all U.S. equities trading volume, generated over $10 billion in net trading revenue and completed more transactions than the New York Stock Exchange. If markets were typically in equilibrium, such revenue numbers would not be attainable as market makers earn no profit in perfect competition.
Takeaway—it pays to be a market maker.
Now that we’ve established the profitability of being a market maker, let’s delve into how firms like Citadel and Virtu generate profit. This brings us back to the bid-ask spread, as mentioned above. Let’s run through an example:
Assume Bob wants to purchase 1 share of ECON at $2040 and Alice wants to sell 1 share of ECON at $2039.95. Here, Citadel will purchase 1 share of ECON from Alice at a bid price of $2039.95 and sell the share to Bob at an ask price of $2040, netting a $0.05 profit from the bid-ask spread.
On the surface, one may wonder how market-making firms generate billions of dollars in trading revenue per year if the bid-ask spread is so narrow. It is only when we consider that such firms facilitate millions of these transactions every day consisting of millions of shares of stock that we realize the degree to which market-making firms are profitable. Furthermore, market-making firms trade not only stock but more complex derivative products such as options, which are less frequently traded. The more illiquid the security, the more market-making firms profit as their bid-ask spreads are wider.
Previously we claimed that market-making firms fill millions of buy and sell orders every day. But how do these firms, such as Citadel Securities and Virtu Financial, secure such a large number of trades? One such method is through a controversial practice called payment for order flow (PFOF). To explain PFOF, let’s return to the trading network pictured above.
Assume that both buyer B and seller S use Robinhood as their broker and that T1 is Citadel. Through PFOF, Citadel pays Robinhood a small fee in exchange for the right to execute trades requested by Robinhood users, who in this example are buyer B and seller S. This effectively eliminates Citadel’s competition (see diagram below), as buy and sell orders entered by millions of Robinhood users are routed directly to Citadel instead of being given to the market maker offering the most competitive pricing.
Paying online brokerages like Robinhood for order flow gives firms like Citadel and Virtu a competitive advantage against competing market makers, as Citadel and Virtu are able to execute a larger volume of trades, resulting in more significant revenue. Accepting PFOF is also beneficial for e-brokers and allows Robinhood, E*TRADE, TD Ameritrade, and other e-brokers to offer commission-free trading to their users.
As we’ve seen through this blog post, market makers are able to leverage their position in the trading network to generate significant revenues. By utilizing PFOF, market-making firms can prevent perfect competition from occurring in the market, thereby realizing profits from the combination of high order flow and incremental profits from the bid-ask spread. With a growing number of participants entering the stock market, the future prospect for market-making firms is bright.
It truly pays to be a market maker!
Sources:
- https://qz.com/1969196/citadel-securities-gets-almost-as-much-trading-volume-as-nasdaq/
- https://www.cnbc.com/2020/08/13/how-robinhood-makes-money-on-customer-trades-despite-making-it-free.html
- https://www.investopedia.com/terms/m/marketmaker.asp#toc-what-is-a-market-maker