Principal Trading

In previous articles, we’ve discussed how, by helping to ensure market liquidity, market makers are integral to the smooth operation of traditional marketplaces, and we’ve looked at how blockchain technology makes true ownership of assets possible. In this piece, we look at principal trading, the concept that underlies the practice of market-making, how it works in the “real world” and how it might work in games. In future articles, we’ll look at asset marketplaces as they operate in the present-day game industry, as well as the new world of decentralized asset exchanges, built on blockchain technology.

What is Principal Trading?

In our prior essay on marketplaces, we looked at the unique role of certain players in providing liquidity in markets — that is to say, ensuring that buyers will find something to buy and sellers will find someone who’ll purchase what they sell. A shortage of liquidity, even a temporary one, causes a marketplace to break down, reducing its efficiency in setting prices and creating frustration for participants. When the friction in a marketplace continually exceeds the benefits generated by trading, the marketplace is unlikely to survive.

This is where principal traders come in.

Principal traders buy and sell assets out of their own accounts, thereby serving as a consistent source of liquidity and facilitating orderly trading. By carrying inventory at their own expense, they’re shouldering risk. But like any participant in a marketplace, they do so looking to make a profit, by smart timing of purchases and sales, or by making a two-sided market in the asset — setting different prices for buying and for selling the same asset, and profiting from the spread between the two quotes.

For instance, a market maker in Widgets Inc. stock may quote a buy-sell spread of $10-$10.05 — offering to buy Widgets Inc. shares at $10 or to sell them at $10.05. The five-cent difference between their two quotes represents a transaction cost to participants in the exchange, and a source of profit for the market maker.

Because they hold their own inventory in an asset, principal traders serve as “dealers” of that asset, in contrast to market participants who represent and trade on behalf of clients — that is to say, “brokers.” Brokers may match orders between buyers and sellers, or between buyers or sellers and dealers in an asset, depending on which form of transaction executes the order the fastest, at the best price possible. In exchange for processing trades, a broker will receive an agents’ fee, also known as a commission, generally a fraction of the value of the asset being bought or sold.

When you see the term “broker-dealer” in financial discussions, it’s because many marketplace professionals take on both roles, holding and managing inventory of their own as well as agenting transactions between third parties. It should be noted that broker-dealers are generally not required to put their clients’ best interests ahead of their own, so long as they behave in a fashion that’s consistent with reasonable expectations given market conditions, conventionally known as the “suitability standard.”

If a broker-dealer can make more money by prioritizing its own inventory over that of its clients, it is entitled to do so, as long as it still executes its clients’ trades in a “suitable” fashion. (By contrast, a registered financial advisor is required to meet the “fiduciary standard,” which is defined as always acting in the best interests of the client.)

Not all principal traders are created alike

While principal traders play an essential role in making markets work smoothly, they aren’t all alike — and their differences frequently relate to the degree to which they are motivated primarily by making an immediate profit on their own trades.

Inventory traders are at the top of the profit-prioritization funnel: They have a supply of an asset and simply want to sell it as fast as possible at the highest possible price.

But other types of principal traders aren’t just trying to unload inventory — they’re also seeking to purchase more assets at a fair price when the opportunity avails itself. While they’re also motivated by profit, their horizon is longer, as they’re constantly replenishing inventory and looking at both sides of the market as a result.

Market makers often, but don’t always, carry a long-term inventory: If there’s enough liquidity in the market, they may simply facilitate trades among counterparties, carrying short-term inventory when it’s necessary to execute the buy-side of their quotes, but unloading it as soon as another purchaser is available. As a result, they are primarily focused on steady throughput rather than profit on individual transactions.

Market makers that do carry an inventory — that is, principal market makers — are often seen as doing so as a service to further juice liquidity in the marketplace. As a result, they may be compensated for their service with rebates or other incentives from the owners/managers of the exchanges on which they operate.

Finally, issuer principal market makers are principal traders who are generally the original source of an asset, and who generally buy, sell and hold inventory as a consequence of providing it in the first place. They derive value from the original issuance — converting the asset into cash — but may be put in the position of making a market in the asset in order to keep the marketplace for it running fluidly. Their priorities as principal traders are often very different from other participants, as they’re seeking to maintain and grow overall activity around the asset rather than necessarily profiting from individual transactions.

How principal trading works in the real world

As we noted earlier, principal trading plays a vital role in marketplaces, where the activity of principal traders provides positive benefits to other participants — further reducing market friction, maintaining trading velocity, and reducing excessive arbitrage — while also delivering profits to the traders themselves.

We’ve discussed the role of designated market makers in securities trading, who facilitate liquidity, enabling buying and selling to be experienced by other participants as continuous. They also often serve as the equivalent of control rods in a nuclear reactor, ensuring that trading doesn’t cycle out of control or collapse entirely, by performing the following functions:

• Making adjustments using their own inventory, acting as a bridge between supply and demand to reduce potential price volatility, i.e., in a buying frenzy, they may provide their own shares to the market until prices cool down
• Spotting errors in trade orders, catching errors that would otherwise cause a stock to be mispriced or a “flash crash”
• Finding buyers and sellers when there’s insufficient liquidity: If bids and asks can’t be matched, they may seek out recently active investors to induce trades
• Running the opening/closing auctions on an exchange, working with other facilitators, for example, the New York Stock Exchange’s Floor Brokers and Supplemental Liquidity Providers, to ensure markets are well-priced at the start and end of trading sessions and that information is being incorporated and disseminated throughout the day.

But not all principal trading takes place on exchanges. In fact, the biggest example of principal trading takes place at the macroeconomic level, via central banks, who engage in principal trading not to earn “profits” but as a policy tool to support societal goals.

Central banks like the U.S. Federal Reserve have mandates derived from both government policy and empirical assessment of the overall state of the economy. They generally seek to maximize employment and keep the economy expanding in a sustainable fashion while also moderating the negative effects of economic expansion, e.g., inflation.

The primary tools they have at hand include direct management of the money supply by altering reserve requirements; raising or lowering the so-called discount rate, which sets the cost of capital for banks and either chills or heats up lending activity as a result; and open market operations, which is the Fed’s version of principal trading.

When the Great Recession arrived post the financial crisis of 2008, discount rates were set to essentially zero in an effort to juice the economy. With that particular tool zeroed out and no longer available, the Fed had only one major option to lower long-term rates and hence borrowing costs: open market operations, in which the Fed spends money to purchase securities, usually Treasury bills, but also other securities as well, on the open market, to create a phenomenon known as Quantitative Easing (QE).

By buying bonds and thus creating demand for them, the Fed forced their price upwards. Higher prices for bonds result in lower yield — the interest rate paid on bonds — which in turn reduces long-term costs for borrowers, encouraging bank activity and stimulating the economy. Since the financial crisis of 2008, the Fed has engaged in four separate rounds of QE, the most recent of which took place in March 2020, and was designed to ameliorate the economic impact of COVID-19.

QE1 (Nov ’08 — Sept ’09): Fed purchased ~ $2 trillion in mortgage-related assets & longer-term Treasury securities

QE2 (Nov ’10 — Jun ‘11): Fed purchased $600 billion in Treasury securities

QE3 (Sep ’12 — Oct. 2014): Fed purchased ~ $85 billion in mortgage-related assets and Treasury securities each month, eventually growing the total size of the balance sheet to $4.5 trillion

QE Tapering (Oct ’14 — Sept ‘17): Fed stopped purchasing new assets but kept the size of the balance sheet constant by replacing securities that matured

QE 4 (March ‘20): The Fed announced purchases of $700 billion in asset purchases to support U.S. liquidity during the Covid-19 crisis.

How principal trading can work in games

In-game economies, just as in the real world, marketplaces must be active, with sufficient liquidity and market information, in order for participants to want to participate. However, when games with marketplaces are just launching, the “cold start problem” can make it hard to get users on board.

As a user base grows, the supply of and demand for goods increases and market interest builds, individuals are more inclined to participate, leading to a “flywheel of engagement.” But generating that initial momentum is a primary challenge for developers — and so is modulating the flywheel to prevent it from going out of control once it has begun to spin.

So how can developers effectively manage in-game marketplaces? One answer lies in the four major activities of principal trading:

Initial Issuance

The game developer, as the issuer of game assets, can distribute an initial stake of those assets to players, as an incentive for loyalty, a reward for activity or achievement, or at a price (in in-game currency or fiat).

Inventory Trading

The game developer can continue to hold an inventory of game assets and sell them to tamp down price growth or to generate revenue for the game.

Principal Trading — Buying & Selling

The game developer can use its own capital to buy/sell game assets from players, creating a market for others, and also a profit for itself. To date, this is rare, as the developer-player relationship is typically one-directional, in the sense that players buy assets from the game and not the other way around. As such, there are few in-game examples of games putting up their own capital to buy and sell game assets for profit.

However, in other industries, this is common — for example, car dealerships engage in buyback programs to maintain their aftermarket price and reputation; BMW’s certified pre-owned program helps consumers distinguish between dealer-certified versus uncertified used cars, maintaining BMW’s reputation for quality, which then affects car prices in both the primary and secondary markets, enhancing BMW’s profit.

Market Making — Facilitating Trades

The game developer facilitates trades of game assets in hopes of generating additional user participation, by serving as a primary counterparty to players — e.g., buying fungible goods (like “leather scraps”) or unique assets (like collectible skins) for the sole purpose of encouraging participation in the marketplace.

This is particularly important when a new set of assets or a new marketplace is launched because the initial order book for assets is usually thin — there may not be an overlap between the bids (buy orders) and the asks (sell orders). When the lowest ask cannot be matched with the highest bid, a transaction cannot happen, freezing the marketplace.

Even without considering the price, a transaction involving a unique asset requires a player to find a counterparty at the time s/he wants to transact, which necessitates mutual interest. This phenomenon, known as the “coincidence of wants” in economics, can be a huge hurdle to overcome. As such, if a game’s long-term objective is to create a sustainable and lively marketplace, it may be in its interest to engage in market-making and stand ready to buy from and sell to players, providing sustainable liquidity to its marketplace.

As we’ve said before, over time, game assets are simply assets, and game economies are simply economies. As such, principal trading in-game marketplaces can serve a role similar to what it does in real-world ones — as an essential way to provide liquidity, ensure orderly trading and drive and sustain growth in the markets for assets.

In future articles, we’ll look at examples of asset marketplaces as they operate in the present-day game industry, and then dive into the new world of decentralized asset exchanges, built on blockchain technology.

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