Market making and high-frequency trading (HFT) are pivotal components of modern financial markets, providing liquidity and facilitating efficient market operations. Despite their significance, misconceptions about these practices are widespread. This tutorial aims to demystify market making and HFT, outlining their roles, participants, and the financial mechanics behind them.
What is Market Making?
A market maker is a firm or individual participant in the financial markets, committed to continuously buying and selling securities at publicly quoted prices. They specialize in certain securities, trading on quote-driven exchanges, and are always ready to buy or sell specific securities. This continuous availability ensures smoother and more efficient market operations by providing liquidity.
How Market Makers Earn Profit
Market makers earn their profit from the spread—the difference between the bid (buy) and ask (sell) prices. They create limit orders, waiting for them to be filled, and strive to execute trades at the best possible bid or offer prices.
Participants in Market Making
Market makers can include banks, branches of banks, brokers, and securities firms. They are often associated with high-frequency trading (HFT) because of their need to trade frequently and at the best prices. However, it’s crucial to note that not all HFT traders are market makers. For instance, many hedge funds engage in HFT without performing market-making activities.
Market Takers: The Other Side of the Equation
Contrary to market makers, market takers are traders or entities that accept the prices offered by market makers. They remove liquidity from the market by executing trades with existing orders, accepting current market prices, and typically seeking immediate execution of their trades, paying the spread for this immediacy.
The Economics of Market Making
Market makers earn a spread on each trade, often rebated at two-tenths of a penny per share, equating to a gross profit margin of approximately 0.01%. This earning mechanism means that if no trade occurs, no profit is made, and a slight decrease in asset value can significantly impact profitability.
The profitability of a market maker is influenced by several factors:
- Bid-Ask Spread: The primary source of income.
- Compensation Costs: Including operational expenses and salaries.
- Price Change: Market movements can affect the value of held positions.
- Carry of the Position: The cost or benefit associated with holding a security.
- Borrowing Costs: Fees for financing operations.
- Hedging Costs: Expenses for protecting against market movements.
- Capital Costs: Including credit risk, counterparty risk, Value at Risk (VaR), and marginal costs.
- Other Costs: Administrative, research and development, and other operational expenses.
In conclusion, market making and HFT are integral to the liquidity and efficiency of financial markets. Understanding the roles, mechanisms, and economic principles behind these practices is crucial for anyone involved in or interested in the dynamics of modern trading and investment.
