Written by: arnaud710
Compiled by: Block unicorn
Market makers: The fantasy of unsung heroes.
Market makers are the unsung heroes of smooth trading; they act like stage managers in the trading arena, maintaining market liquidity and seamless transactions while balancing countless factors to keep stability. Building an efficient market-making system is akin to creating a high-performance car — every component needs to operate perfectly to deliver top performance.
What is market making?
The core of market making is providing liquidity to financial markets by continuously quoting bid (Buy) and ask (Sell) prices to offer trading opportunities for securities. Market makers profit from the bid-ask spread, which is the difference between the buy and sell prices. You can think of them as friendly local shopkeepers who always have stock to sell and are also willing to buy back goods, ensuring that buyers and sellers do not leave empty-handed.
Bid-Ask Spread: The core of market making.
The bid-ask spread is key to market makers’ profitability; it not only covers the risks and costs of holding inventory and facilitating trades but also determines whether market makers can attract traders.
Wider spreads: While they can yield higher profits, they may scare away traders looking for tighter prices.
Narrower spreads: Can attract more trades but yield lower profit margins.
The key is to find a 'sweet spot' — if the spread is too wide, your inventory will be unsold; if it is too narrow, your profits will be minimal. A well-adjusted spread helps market makers cover costs while remaining competitive.
Inventory holding premium (IHCi): The art of balance.
Market makers will hold a certain inventory of securities to facilitate trading.
The cost of holding inventory: Comes from two main aspects.
1. Opportunity cost of capital.
Holding inventory ties up capital that could be used for other investments. If the price of securities increases, the required spread will also widen to compensate for this cost. This can be seen as high-end products requiring higher pricing because they demand more resources to produce.
2. The risk of price volatility.
The securities market is highly volatile, and price changes can lead to losses. If market prices move in an unfavorable direction, market makers will incur losses. To guard against this risk, market makers often widen the spread to provide a buffer for adverse price changes.
This approach explains the interactions between securities prices, volatility, and holding durations, ensuring that premiums can adjust with market conditions.
Adverse selection cost (ASCi): Guarding against informed traders.
Adverse selection refers to traders having high-quality information about the future trends of securities that market makers do not possess. To prevent potential losses from these informed traders, market makers need to adjust spreads for protection.
For example: If someone knows a stock is about to surge, they might buy at the selling price, and if the stock price does not rise as expected, the market maker could incur heavy losses. By incorporating ASCi into the spread, market makers can mitigate risks arising from information asymmetry.
Information trading probability (P_I): Assessing risks.
Assessing the likelihood of facing informed traders is a complex task that requires analyzing patterns and market data to determine whether trades are based on insider information. Factors such as trading frequency, volume, and historical price trends can all influence this judgment.
A higher P_I: Indicates a greater risk of adverse selection, and market makers may widen the spread.
A lower P_I: Indicates less risk, allowing the spread to narrow, which encourages more trading activity.
Competitive agents (H′): Measuring market competition.
Competition among market makers affects the width of the spread; the more intense the competition, the narrower the spread tends to be, as market makers need to attract traders. H′ can be calculated based on the concentration of market makers for specific securities.
Formula: H′=ViXH′ = \frac{V_i}{X}H′=XVi
ViV_iVi: Trading volume contributed by specific market makers.
XXX: Total trading volume.
A higher H′ value indicates less competition and higher concentration, leading to wider spreads; conversely, in more competitive environments, spreads tend to narrow.
Understanding the core principles of market making through vivid analogies.
Opportunity cost: Imagine your capital is your best salesperson. If you have them spending all day making cold calls instead of landing high-value orders, you are missing out on huge profits. By allocating funds wisely and ensuring your 'money-making experts' focus on the right tasks, you can widen the spread and earn more.
Volatility: Think of volatility as a person bouncing on a trampoline; you can never predict the height or direction of the next jump. Market makers must stay steady and not be thrown off by these fluctuating market conditions.
Adverse selection: Adverse selection is like watching a soccer game where some spectators secretly know the outcome. Market makers need to set the spread accurately to avoid being led by these cunning 'insider viewers' and to avoid falling into their traps.
Building a complete market-making system is much more complex.
In summary, the art and science of market making play a crucial role in ensuring market liquidity and smooth trading. Building an efficient market-making system is a skill that combines both art and science. It requires deep technical knowledge, precise strategic adjustments, and the ability to quickly adapt to rapidly changing market dynamics.
Through careful operation, market makers ensure that financial markets remain liquid and efficient, providing important support for the stable development of the entire market ecosystem.