Investors Misled by Market Making Mythology
Exposing the market making claim of high frequency traders as a myth, continues our effort to uncover predators in rigged markets! Today our continuing White Top View Series, High Frequency Trading, discusses the myth of high frequency traders as market makers. This high frequency trading series began with links to the CBS News program, 60 Minutes, Exposed! Market Rigging and High Frequency Trading. That program, based on the great Michael Lewis book, Flash Boys, started the first serious public look at how very well obscured high frequency trading activity, rips off real investors.
Links to all parts of the White Top View Series, High Frequency Trading are at the end of this post.
Last time, in Exorcising Another High Frequency Trading Devil, that White Top View post discussed the price discovery myth claimed by those supporting capital market rigging. Four major mythical benefits we expose include: better volumes, superior price discovery, market making and narrowed price spreads.
This time, we deal with the third myth often used to sell high frequency trading as beneficial to you and markets.
High Frequency Traders Market Making Myth
High frequency traders market making myth attempts to positively link market rigging to a long-established and essential role in markets. To understand that market making claims by high frequency traders are mythical nonsense, you must have a basic understanding of market making itself.
Historically, market making companies or individual market makers had a well established, traditional and very useful role in markets. In essence, a market maker sees that both buyers and sellers of a security can trade. Market makers accept responsibility to trade and hold inventory in a specific security. That allows investors to confidently place orders to buy or sell with expectations of prompt and fair execution.
Basic Market Making
Imagine a simple market with only you and me as buyers or sellers. Lets say you want to sell 1,000 shares of a company that I want to buy. Without a market maker, our orders for the same amount to sell and buy must meet in the market at the same time. If you place your order hours before me, no trade can happen. The market maker, in our simple example, knows the company we wish to trade routinely attracts orders for 1,000 shares a day.
By taking the other side of each trade, the market maker ensures the market worked. Although we placed our orders some time apart, our separate orders to buy or sell were both filled. The market maker served the valuable role of making a market for us. They bought when you wanted to sell. They sold when I wanted to buy.
Add variables such as changing your order to 500 shares or mine to 2,000 and our simple market would immediately stop trading without the help of market making. Once we add in millions of other investors and orders through time, across thousands of companies, we appreciate that it very quickly gets very complicated.
Buyers and sellers need each other. Otherwise no trade happens. Market making smooths the process and calms price volatility. Prices must still move under buying or selling pressure, but market making modulates or dampens the rate of change and avoids or at least resists extremes.
Think of them like shock absorbers providing added safety and a smoother ride down the market highway. The bumps, dips and hills are still there, but market makers improve the ride.
You likely benefited from market making when you purchased foreign currency for a trip out of the country. For example, using U.S. dollars to buy Canadian dollars gets quoted at a specific price. Doing the reverse, selling Canadian to buy American, gets quoted at a different price. That difference is the spread. The spread serves as the margin the dealer or bank takes as profit. That is market making.
For most investors, the NASDAQ market provides the most readily seen example of market makers in operation. As retail investors, we place a buy or sell order for a security listed on that exchange. That order gets electronically routed to the screens of multiple market makers assigned to each listing. They are among the hundreds of market making firms. The thousands of broker-dealer firms see and can trade those orders.
The market makers accept the risk of holding inventory in the assigned security to help trading. Market makers in the same security compete by displaying buy and sell orders for a guaranteed number of shares. That competition, the inventory obligation and transaction guarantee are essential elements of market making.
Market makers chase the spread or hope to make profit by selling slightly above the price they pay to buy. They hope to make good money by making a small profit on the spread over many thousands of transactions. That spread is kept narrow by competition between market makers.
To make a business of market making and profit from the spread over thousands of transactions, means accepting risks. The risks include accepting the obligations of holding inventory and providing a guaranteed minimum trade.
Three Strikes On This Myth
To understand the high frequency traders market making myth we can check the count on their market making pitch.
- High frequency traders close each market day with no inventory. Strike One!
- High frequency traders never get assigned the traditional market making role. Strike Two!
- High frequency traders accept no obligation to trade and never guarantee a trade. Strike Three!
Three strikes and you are out in baseball! But high frequency trading in rigged markets remains to play!
Three Strikes, Market Making Myth Is Out!
The myth strikes out but high frequency trading remains very ready to reach into your pocket on every order. High frequency traders seek risk free ways to rip off a profit by paying regulators and exchanges to take advantage and use technology to rig markets. That is not market making! High frequency traders only move after they discover real orders from real investors. Real market makers are in place with bid and ask prices before we or other real investors place an order.
Next time we discuss the fourth big justification myth, narrowed price spreads!
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Links to the White Top View Series, High Frequency Trading
Part 2: High Frequency Trading and You