Market Making, All You Need To Know!!
By QuantVan on Altcoin Academy
In this article, we are trying to describe market-making from different angles.
Market Makers Goals
Market making does not set prices, but they do reduce price volatility, assuring the public of better and more accurate prices while trading in open markets. Market making dealers are found on all financial, futures and over-the-counter options markets are probably essential to the functioning of any open and fair market which liquidity is important.
The above market situation may easily be reflected with the elementary supply/demand curve.
Economics activity that leaves total wealth unalerted or merely shifts existing wealth is not necessarily useless or harmful, however.
For future markets to perform price discovery and risk shifting functions successfully, future markets participants must include other market traders in addition to commercial hedgers. These traders are scalpers, market makers and speculators. Scalpers and market makers assume that portion of risk that commercial hedgers or speculators wish to shift temporarily. But eventually wish to neutralized. Speculators ultimately assume the risk that commercial hedgers and market makers do not want. In effect market makers and speculators distribute the unwanted investment risk of commercial hedgers and perform the insurance factor to industry.
Turning to the alternative sequencing of the trading game, liquidity suppliers first post schedules of limit orders which are then hit by a market order. This sequence corresponds to continuous trading in electronic limit order books. Along with strategic considerations, the price schedules arising in equilibrium reflect the costs faced by the liquidity suppliers.
The scope for market power is different in the two trading mechanisms, however. In the first one, liquidity suppliers can earn rents even if they are risk-neutral. In the second one, rents arise only under risk aversion, which is necessary to ensure increasing marginal costs. This reflects the different forms of competition arising in the two market environments. The uniform {price auction induces Cournot behavior, while the discriminatory {price auction induces Bertrand competition. Rents can be earned in the former case, even with constant marginal cost. In the latter, rents can be earned only if marginal cost is increasing.
Decline In Dealer Risk-Taking Capacity And/Or Willingness.
One apparent trend is market-makers’ increasing focus on activities requiring less capital and balance sheet capacity. In line with this development, banks in many jurisdictions report allocating less capital to their market-making activities and are reducing their inventories by cutting back on their holdings of, in particular, less liquid assets.
Increasing Differentiation And Greater Focus On Core Markets.
A number of market-makers have reportedly adopted a more selective approach to offering client services (eg focusing on core clients), whereas others are narrowing the scope of their services (eg focusing on a smaller range of markets). In many jurisdictions, market-making has been shifting towards a more order-driven and/or brokerage model.
As a result, the execution of large trades tends to require more time, with many market-makers being more reluctant to absorb large positions.
Diminishing Proprietary Trading By Banks.
Proprietary trading has reportedly diminished or assumed more marginal importance for banks in most jurisdictions, particularly in the euro area. Expectations are for banks’ proprietary trading to generally decline further or to be shifted to less regulated entities in response to regulatory reforms targeting these activities. This contrasts with trends in individual jurisdictions, particularly in Asia, that have been less affected by the recent crisis.
Growing And More Concentrated Demand For Immediacy Services.
Primary bond market expansion amid significant flows of funds to market participants that require immediacy services point to growing demand for market-making. There are also signs of increasing concentration among market participants that demand immediacy services, such as asset managers. As a result, market liquidity could become more dependent on the portfolio allocation decisions of only a few large institutions.
Adjustment In Trade Execution.
Portfolio managers are adjusting the way they execute their trades to the changing costs and availability of immediacy services. Some are increasingly exploring trading strategies that split transactions into smaller amounts or use other means to optimize trading performance. While these adjustments would tend to mitigate the effects of rising demand for immediacy services, the associated costs (eg for IT infrastructure investments) may be difficult to bear for smaller firms.
Expansion Of Electronic Trading.
The use of electronic trading in bond markets has been growing, although from relatively low levels, with market participants seeking more price transparency and cheaper trade execution. Trading platforms (if not single dealer-based) tend to support market functioning by pooling liquidity from multiple dealers. That said, existing electronic platforms are often used only for a limited range of typically standardized and smaller-sized transactions, and they often remain dependent on the provision of immediacy services by the same entities that otherwise provide liquidity outside of these platforms.
The Role Of Market Makers In Bond Markets
Primary and secondary bond markets are closely related, with many market making firms active in both. Bond issuers generally have an incentive to improve the liquidity of their issues in secondary markets to reduce the premium that investors demand. Many jurisdictions have thus adopted primary dealer (PD) systems for central government bonds that often combine incentive schemes with market making obligations
- provide immediacy services to clients and other market participants, ensuring market liquidity and supporting price discovery;
- contribute to the robustness of market liquidity by absorbing temporary supply and demand imbalances, dampening the impact of shocks on market volatility and quoting prices to support investors in valuing assets.
Market Making In-House And Market-Related
Market Maker’s Profit And Loss (P&L)
Trading Platforms In Fixed Income Markets
Electronic trading is a broad term for various methods of conducting trades electronically. To better understand the incentives for switching from voice-brokered trading to electronic trading and the resulting impact on market making, it is instructive to differentiate trading platforms according to how and which participants provide liquidity.
Order-Driven.
In an order-driven market, trades are matched on a central limit order book, where market participants can place orders anonymously. While such platforms often rely on designated market-makers, who commit to providing a minimum of quotes, any market participants can contribute to market liquidity by placing limit orders on the central limit order book.
Quote-Driven.
In a quote-driven market, dealers provide quotes upon request of a client (request for quote — RFQ). This is the prevailing model in bond markets. In contrast to order-driven markets, only dealers can provide liquidity to the market. Clients, therefore, remain dependent on immediacy services provided by the same market makers that otherwise provide liquidity off these platforms. Different forms of dealer platforms exist:
Single-Dealer Platforms
Represent extensions of traditional voice-brokered trading, allowing clients to access an individual dealer’s quotes on screen, where prices may be merely indicative (ie not executable as in order-driven markets). While these platforms can contribute to reducing the cost of transactions by benefiting from lower operational costs than voice-brokered trading, the role of the dealer in providing immediacy services to clients remains essentially unchanged.
Multi-Dealer Platforms
By comparison, allow clients to simultaneously access or request quotes from several dealers. Clients generally benefit from more favorable prices, given increased competition among dealers and enhanced market transparency. In addition, many platforms provide incentive schemes for the designated market maker to enhance liquidity. These additional advantages help explain why the market share of multi-dealer platforms has significantly increased in recent years, whereas single-dealer platforms have often stagnated.
Accordingly, the use of electronic trading platforms in bond markets has been growing in both advanced and emerging markets, although often from relatively low levels compared to electronic trading activity in equity markets.
you can read more about market-making, in our market-making archive.
