Overrated biases about Market Makers
Market Makers (MM) play a crucial role in the markets, but they are associated with questionable practices in the imagination of individual traders.
In the Forex and CFDs world, one recommends to stay away from them because they would cause their clients to lose, and to rather trade with mere brokers, the majority of whom are adorned with acronyms like NDD, STP, DMA etc. In the cryptocurrencies world, MM are associated with wash trading, an activity that aims to artificially inflate transaction volumes on exchanges to mislead users.
Since our financial protocols won’t work without MM, and will allow everyone to become one (which we prefer to call liquidity providers), it seemed important to understand the real role and value of MM.
For convenience, we have allowed ourselves a lot of simplifications.
A bit of history
At one time, financial markets were very different and illiquid, making it difficult to find a buyer at the price at which you desired to sell, and that could ruin your strategy.
To overcome this problem, markets stakeholders began to do some market making, which consisted in becoming the counterpart of the investors, at almost all the prices, for almost all the quantities. The main role of the MM is therefore to provide liquidity, a sine qua none condition [MOU1] to attract and keep investors on the platform they operated in. To attract MM to their platforms, exchanges could waive their transaction fee, or even paying them through a rebate, a share of the fees their customer paid to trade.
As MM take a risk by being a counterpart, they have developed an arsenal of strategies to optimize or even reduce it. The most basic still used today, is to offer the best purchase price and the best sale price at the same time; if a buyer and a seller come on the platform to open a position, it will happen at these prices, and the MM will be both seller and buyer, therefore neutral, and will collect the spread (the MM sells high to the buyer and buys low to the seller). Of course, it is not as simple, several MM compete with the same strategy on the same market, and it is possible that only one of the orders is taken, exposing the MM to the movements of the market.
Forex and Market Makers
How does an MM work in the Forex and where does their bad reputation come from?
Your broker himself has his own broker, a liquidity provider to be more precise. The broker opens an account with this supplier, which can be yet another broker who also has a liquidity supplier, or a bank, a hedge fund, or an institutional exchange.
When you open a position, your broker has two options: either it behaves like a No Dealing Desk (NDD) broker or like a Dealing Desk (DD) broker.
NDD broker
When you open a position via an NDD broker, it acts as an intermediary between you and your counterpart (its liquidity provider). He charges a commission or adds a little spread to make his butter. There are therefore no conflicts of interest: whether you win or lose, the broker collects his commission.
DD broker
The DD of the broker is in fact an algorithm which will analyze the positions of its customers, to determine their level, and estimate if it is more profitable to be their counterpart and therefore to cash their future losses (we use to call this practice to B-Book), or to try to remain neutral and only collect the spread like a NDD broker (A-Book).
Fun fact 1, for a MM, a risky or toxic client is either a trader who wins, uses a robot, or is a scalper.
Fun fact 2, customer data can also be used to train algorithms via machine learning to better anticipate market or understand how the crowd of individual investors reacts to different market movements. Not for science, but rather to profit from it. It is as example the business model of Robinhood, commission-free trades whose data are sold to huge MMs like Citadel.
If the MM is the counterpart it may create a conflict of interest. However, this is not a bad thing in itself! Since most traders are losers, whether the MM is the counterparty or not, if he does not manipulate his platform to make his client lose, why should he deprive himself of it?
You have no problem going to the casino, playing against the house, as long as you know there isn’t cheating.
This allows MM to make more money than an NDD broker, and therefore to have better service; moreover, since only a small part of the trades is outsourced, the MM can offer its own prices, with better conditions and better execution; or even no commissions.
However, this system has limits
If a broker badly manages the risk of his B Book, in the case for example where traders earn more than they lose, and that the broker’s financial capacity cannot absorb these gains, he may lose money or even go bankrupt.
This is what happened in 2017 when most MMs supplying Bitcoin in CFDs were close to bankruptcy. Instead of hedging their risk on exchanges, they bet both on the fall of the BTC and against their customers….
Note that in the event that the exposure of the B-Book begins to be dangerous, the MM has different possibilities such as reducing its exposure on an instrument where it loses a lot of money. Some MM even go as far as borrowing money in order to maintain their exposure… Less frequent, but very useful, they can use the concept of mutualized loss: they reduce the profits of the winners by a painless percentage, in order to reduce losses or even to cancel them.
Another limit to the system is greed: in practice, nothing prevents them from manipulating their platform to earn more money, hence conflicts of interest and their reputation…
One step away from being a scam…
Some MM in the Fx and CFD sector have started to be attracted to easy money, and to use amoral or totally illegal methods to make a living.
Companies that develop trading interfaces and platforms have added functionalities allowing the broker to modify their spread if a client’s stop is near, to slow the price feed if they uses a robot, or to freeze the platform in case of large price movement. MM can play with a large number of parameters to alter the trading conditions of users.
If we add the many scams that raged during the explosion of online trading (binary options, false account managers, false brokers etc.) the shortcuts were quickly made, and have forever link the words Market Maker and Dealing Desk to scams in the collective imagination.
Market Makers in crypto
How does an MM work in the crypto market and where does their reputation come from?
In the world of cryptocurrencies, MM has the noble role to provide liquidity. Unlike Forex and CFDs, which are very liquid markets, cryptocurrencies are still immature and illiquid and are traded over-the-counter via exchanges (see our article broker vs exchange); the explosion in the number of exchanges has fragmented an already poor liquidity, creating an inefficient market.
In fact, the role of MM is to correct these inefficiencies by providing liquidity. Either by reducing the spreads on exchanges (as explained above by providing both buy and sell prices), or by arbitrating the price differences: unlike the price of a share, which is set centrally and which is the same throughout the planet, the price of cryptocurrencies varies from one exchange to another depending on the supply and demand on their platform; a MM will bring liquidity to these two exchanges by selling on one and buying on the other, collecting the difference and effectively reducing the price difference.
However, the term market making is understood as something harmful… the fault of certain exchanges and projects having led an ICO, lovers of wash trading…
Wash trading
Technically, wash trading is simple: two robots buy and sell several assets between them, the losses of one going to the pocket of the other. No commission is paid thanks to the complicity of the exchange, and this is how false volumes are generated without costing them a penny, but the cost of the service or the robot provided by unscrupulous MM (often three developers in their student rooms in Ukraine or China).
The goal is to give the impression that the exchange has a deep liquidity and many users. This results as being ranked at the top of listing website such as CoinMarketCap, ensuring low cost advertising to attract users. This also helps to attract ICO projects which issued a token; very often they have been raising several millions, and can afford to pay from 15,000 to over 1,000,000 dollars to be listed on top exchanges with a lot of liquidity and thousands of users, in order please their investors.
While wash trading is a service offered by self-proclaimed MMs for exchanges, some have also started to directly address ICOs, offering their “market making” service along with token listing one (we received at least 3 proposals per day during our ICO). Since many exchanges threaten to delist your token if it does not garner enough volume, using this type of service helps avoiding this type of sanction.
To conclude…
All business sectors are facing good and bad players, and we often retain the bad; plumbers, mechanics and locksmiths that exaggerate their prices to defraud people, deputies and senators who would be lazy and corrupted.
Do not let the voices and isolated cases taint an entire sector: MM are an essential piece of the financial sector and will remain so.
Vsevolod.
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