If you ask most financial institutions they would say the service they provide is "liquidity" - they let you put your money in or take your money out at any time (in exchange for securities), as well as make decisions about where you want to allocate your capital based on your personal view of the world.
This always fell a little flat to me (hence why I left the financial industry early in my career), but it's pretty analogous to merchants or retail. What service does a storefront provide, other than marking up the wholesale price of a good by 3x? They offer convenience - you can buy anything you want at the time you want it just by picking it up and swiping a credit card, vs. having to contract with a wholesaler for delivery, which might be months in the future, at a place that's convenient for the wholesaler, and needing to buy in quantities that no individual really needs. So it is with brokerages & exchanges - they let you buy any security with a couple clicks of a button, vs. needing to get an ISDA and pay a lawyer to write a contract, plus find someone else that wants to trade with you, plus take on the risk that your counterparty goes insolvent. And so it is with market-makers like Citadel or Jane Street: they ensure that you can always find a buyer for your securities (for a price), and that you don't have to worry that about simply not being able to sell stocks at any price.
> If you ask most financial institutions they would say the service they provide is "liquidity".
I've honestly never understood this. Economics 101 teaches us that artificially manipulating supply (liquidity) is at direct odds with a free market's ability to do price discovery. If there is effectively infinite supply of any security (because all these high frequency firms are instantly hedging out the risk against their entire portfolio), why should anyone believe the NBBO? It's just a made up fantasy number at that point. It doesn't represent what the real security is worth because there are an infinite number of buyers and sellers willing to transact at any moment.
HFTs and other market makers are time- and risk-shifting supply & demand. In a functioning market, you can always find someone else to take the other side of the trade if you wait long enough, but you may not be able to find them now. Particularly in market panics, where all the buyers tend to disappear at once.
What a market maker does is say "Sure, I'll take the other side of the trade - right now, at this price, even though I don't actually need or want the security. And I'll take on the risk that I might not be able to find a counterparty later. I trust my knowledge of the market enough to believe that the price I've offered you is one where I can profitably unload it later." And if they're wrong about gauging future supply & demand, they go bankrupt. Markets function on survivorship bias; repeat this cycle for long enough and the only market makers left are those that are extremely good at gauging future supply & demand and using it to set spot prices.
On some level, they're arbitraging risk & rationality. A retail investor makes a trade that is locally rational - perhaps they need to sell stocks to pay taxes, or purchase a home, or they've lost their job and need a savings cushion. And many of these events affect multiple people all at once (eg. everyone paying taxes on Apr 15, home sales peaking in the spring and declining in December, a recession causing people to lose their jobs all at once), which leads to temporary declines in demand that don't at all reflect the discounted value of all future cash flows of the stock market. Market makers smooth out these fluctuations, buying & selling stocks when it's globally rational based on the fundamentals of the companies and holding inventory when short-term supply does not match long-term supply.
> HFTs and other market makers are time- and risk-shifting supply & demand. In a functioning market, you can always find someone else to take the other side of the trade if you wait long enough, but you may not be able to find them now. Particularly in market panics, where all the buyers tend to disappear at once.
Time shifting risk would be perfectly fine if market makers had to play by the same rules as everyone else in the market, but they don't. They get to ignore certain rules, which results in distorted prices because they can effectively accept infinite risk over an infinite length of time.
Let's say there's suddenly a run-up of $WEN and I, as a retail investor, want to short it because I think the price will surely come back down eventually. If it continues to go up, ultimately I get margin called and have a very short period of time to produce a lot of money to keep that trade open, otherwise I'm liquidated. There is a (risk * time) maximum before I, the retail investor, ultimately go out of business.
Market makers are exempt from this. They are legally permitted to short stock by conjuring phantom shares from thin air without having to locate borrows to satiate the buying demand during the run-up and wait effectively an infinite amount of time to repurchase the shares. There is no limit to their (risk * time) budget. Better yet, when the underlying company ultimately goes bankrupt from the stock being cellar boxed into the ground, the market maker can just wrap up all the worthless, sub-penny shares into a zombie holding company which lives forever, so they have never close the trade and actually pay taxes on the ill-gotten gains. Meanwhile, nobody seems to bat an eye at tens of billions of "securities sold, not yet purchased" on the market maker's balance sheet, because hey, as long as the SEC remains a wet noodle thanks to regulatory capture, they'll never get charged with fraud and the music keeps playing.
It's a system that has been deliberately structured to screw over average retail investors and concentrate wealth behind a few large market making firms, which incredulously all have their own hedge funds (which is somehow not seen as a hilariously brazen conflict of interest). Whenever anyone asks why all this complexity is necessary, the "We provide liquidity, so you can trade right now, for free!" line is trotted out and they hope you go away so they can continue running their shell game. Our markets have become addicted to this fake liquidity, which is ultimately backed by an infinitely expanding risk balloon. As long as the balloon never pops, the game is still on.
> artificially manipulating supply (liquidity) is at direct odds with a free market's ability to do price discovery. [...] there are an infinite number of buyers and sellers willing to transact at any moment.
No, there are not. There is a limited (and not really that large) number of active participants in any given market segment, and the 80/20 rule holds among them pretty well too. Thanks to Money Stuff it dawned on me recently that market makers are not really providing liquidity. They provide immediacy. Buyers and sellers have to meet not just in price, but in time too.
The spread paid by market participants should be seen as their baked in commission for providing a very specific service: reduced wait time. We can certainly disagree about the societal value of what that service has morphed into, but the reality is that for other than the most liquid[ß] assets, participants are willing to pay extra for the ability to transact NOW, and not in some unspecified time in the future.
My personal opinion is that NBBO is an imperfect mechanism to set upper bounds to these commissions. In other words, it limits how much retail transactions can be fleeced for.
I am without a doubt a retail investor: I generate maybe three transactions a year, and I'm happy to pay something like 0.15% to 0.25% transaction fee each time, in the knowledge that I am getting a fair price at the time. To me that is a reasonable cost of convenience. My transactions are so small compared to the trading volume that they have zero price impact: in purely financial terms I could be paying a smaller commission if I set up the limit order thresholds myself - but that would take more time and be less convenient.
[ß] Read: continuously traded in very large quantities
The average retail investor just does not need that much liquidity, especially if they're not buying individual stocks (which by and large they shouldn't be).
And the average retail investor pays pennies to market-makers - if a typical spread is 1-2 cents and you make 5 trades a year, you've paid between a nickel and a dime.
As with advertising, when you sum up dimes across hundreds of millions of people, it becomes an appreciable amount. Particularly when you also include trades made by institutions on behalf of retail investors. Your 0.5-1.5% management fee on an actively-managed mutual fund is partially going to pay salaries for the fund manager, and partially toward brokerage commissions, spreads, etc. for the trading itself. And mutual funds care a great deal about getting liquidity when they need it, since they're in breach of contract if a flood of redemptions come in and they can't liquidate assets to pay them.
(Market makers are also analogous to the credit card industry in that a small fraction of dumb people subsidize a large number of fiscally responsible people. If you get a rewards card with no annual fee and always pay it off on time, you turn a profit, paid for partially by merchant fees and partially by idiots who carry a huge balance at 25% interest rates. Similarly, if you buy-and-hold a good stock or index fund, you're making profits far in excess off what the financial industry can skim off you. The suckers are largely made up of day traders, wage slaves who can't save anything, and underfunded pension funds with principal agent problems.)
> Your 0.5-1.5% management fee on an actively-managed mutual fund is partially going to pay salaries for the fund manager, and partially toward brokerage commissions, spreads, etc. for the trading itself.
Good post but your management fee isn't generally paying for crossing the spread. That's extra slippage.
It may show up as tracking error in the fund (the price was 10.25/10.26, the fund had to buy, it bought at 10.26 and the index trackers said the price was 10.255, it had 0.5c of slippage). But more likely the fund traded in the closing auction, there was only one price so it officially had zero tracking error, but the price was silently a little higher than it would have been if the fund wasn't buying.
This always fell a little flat to me (hence why I left the financial industry early in my career), but it's pretty analogous to merchants or retail. What service does a storefront provide, other than marking up the wholesale price of a good by 3x? They offer convenience - you can buy anything you want at the time you want it just by picking it up and swiping a credit card, vs. having to contract with a wholesaler for delivery, which might be months in the future, at a place that's convenient for the wholesaler, and needing to buy in quantities that no individual really needs. So it is with brokerages & exchanges - they let you buy any security with a couple clicks of a button, vs. needing to get an ISDA and pay a lawyer to write a contract, plus find someone else that wants to trade with you, plus take on the risk that your counterparty goes insolvent. And so it is with market-makers like Citadel or Jane Street: they ensure that you can always find a buyer for your securities (for a price), and that you don't have to worry that about simply not being able to sell stocks at any price.