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I've never understood the claim that "market makers" are providing a valuable service in the stock market by providing liquidity and reducing spreads. If this i

I've never understood the claim that "market makers" are providing a valuable service in the stock market by providing liquidity and reducing spreads. If this is a necessary service, why aren't there market makers in every market? My local grocery wants to sell bananas for $1.50 a pound, but I only want to pay $1.00. Why isn't there a market maker buying and selling these bananas thousands of times per second to reduce the spread between me and my grocer so we can meet in the middle? oh right, it's because the market takes care of that for us. If others are happy paying $1.50 the grocer will stay at that price and I'll have to accept it or go without my bananas. If most buyers agree with me the grocer will have to lower their price if they want to sell the bananas. No market maker is needed.

mpyne 13y ago
> No market maker is needed That doesn't mean that market makers don't provide value, just that they are not necessary.
- DougWebb 13y ago
  I don't see the value; I never have. I understand that the market maker is able to extract profit from the spread, but they keep that for themselves. The original buyer and seller don't gain anything they wouldn't have gained otherwise, and it seems likely that one or both of them lose out on a share of that spread-profit.
  - mpyne 13y ago
    I don't even own stock, but I believe the "value" is as simple as a reduction in the price for the buyer, along with an increase in liquidity for the seller, along with a reduction of the spread for both (which should make it easier to budget and make predictions).
maxerickson 13y ago
Your grocer is a market maker! To the point that the word market is often used for small stores. If you had to buy bananas off a truck when it happened to be in town, you'd get a lot less bananas and you'd pay more for them.
- DougWebb 13y ago
  I don't think that's true. It's certainly more convenient for me to go the grocer and know that, usually, they'll have bananas for sale. However, during the summer in my town there is a farmers market every week, where I actually can go and buy produce off the back of a truck. The prices are often cheaper and the products are often better. (Sometimes the prices are higher, but that's because the products are better: organic, varieties that don't ship well, etc.) I can take this one step further, and actually go to many of the farms around here to buy produce right off the plants, by picking it myself. Even less convenient, but it makes for a nice weekend outing, and the prices are even cheaper. Note that in both cases the prices drop for me and stay the same for the farmer by cutting out middle-men: the shippers, the grocer. By your terms, those are the market makers, and while they make produce commerce more convenient they're certainly not reducing costs for anyone. They're taking profits out of the parties on the two ends of the transaction. I'll grant you that, in my example, the middle-men provide an essential service by giving me access to produce that is not produced locally, and by making that access more convenient. Neither of those apply to the financial markets though: as purely information-driven markets, they're accessible 24/7 from anyplace in the world. So again, what value are the market makers actually providing to the buyers and sellers of financial products?
  - maxerickson 13y ago
    Fair enough, the words about cheaper are arguable. I wouldn't want to try to buy bananas in a world where there was no one willing to take them off the truck and hold them for a few days though. As far as financial markets, reliable prices are worth something (even though a reliable price is 'just information'). I agree that in heavily traded instruments, providing liquidity becomes a fairly abstract value, but if you are a large institution, having someone that will readily purchase enormous amounts of shares is a valuable service. For a lightly traded instrument, being able to sell it is also a valuable service. I don't see enormous value in having lots of people spending lots of money chasing pennies, but I have trouble getting worked up about it. I suppose what it comes down to is that I am skeptical that rules designating who gets the tiny bit of slop available in financial transactions will be any more fair than the present system (where various HFTs are competing for the slop, often by essentially offering some of it to the parties in the transaction...).
ig1 13y ago
You seem to be confusing a few different things here. One of the fundamental purpose of a market maker is ensuring that both the supply and demand sides are capable of transacting when they want to, even if the supply and demand side don't necessarily want to trade at the same time. So say the farmer only wants to sell bananas on a Monday and you only want to buy them on Thursday, so you can never do the transaction. So your grocer by buying the bananas when they're available and selling to them when you want them is in fact taking on some of the role of a market maker. The reason that bananas don't need high-speed market making however is that the underlying supply and demand for bananas is pretty stable (I'm just guessing here; I don't know anything about the banana market). With currencies the supply and demand is in constant shift, everything from news events to someone making an online purchase in a foreign currency contributes to the shift. So a large part of the premium you pay for currencies is to manage that risk of the underlying supply/demand shifting. So by reducing that risk you can have lower premiums. Say your grocer bought their bananas at $1 and was selling them at $1.50, what percentage of that 50 cents do you think goes towards managing the risk that the demand for bananas will collapse and the bananas might not be worth $1 any more ? - I'm guessing none of it because the bananas will likely spoil before the price of bananas shifts that much. Hence reducing that risk is pointless in the banana market. HTH
gus_massa 13y ago
On the other hand, if your local grocery wants to sell bananas for $1.00 a pound tomorrow (because the have no banana today), but you want to pay $1.50 but you need them now (because you have a party), then someone with a scooter and a nearby warehouse can go and find some bananas for you (at $1.50) and replenish the banana stock tomorrow (at $1.00). Probably this business will not work with bananas, because bananas rote, the fuel cost and the time someone has to sit in front of the groceries. It's easier to implement with stocks and bonds.

mpyne 13y ago

> No market maker is needed That doesn't mean that market makers don't provide value, just that they are not necessary.

DougWebb 13y ago
I don't see the value; I never have. I understand that the market maker is able to extract profit from the spread, but they keep that for themselves. The original buyer and seller don't gain anything they wouldn't have gained otherwise, and it seems likely that one or both of them lose out on a share of that spread-profit.
- mpyne 13y ago
  I don't even own stock, but I believe the "value" is as simple as a reduction in the price for the buyer, along with an increase in liquidity for the seller, along with a reduction of the spread for both (which should make it easier to budget and make predictions).

maxerickson 13y ago

Your grocer is a market maker! To the point that the word market is often used for small stores. If you had to buy bananas off a truck when it happened to be in town, you'd get a lot less bananas and you'd pay more for them.

DougWebb 13y ago
I don't think that's true. It's certainly more convenient for me to go the grocer and know that, usually, they'll have bananas for sale. However, during the summer in my town there is a farmers market every week, where I actually can go and buy produce off the back of a truck. The prices are often cheaper and the products are often better. (Sometimes the prices are higher, but that's because the products are better: organic, varieties that don't ship well, etc.) I can take this one step further, and actually go to many of the farms around here to buy produce right off the plants, by picking it myself. Even less convenient, but it makes for a nice weekend outing, and the prices are even cheaper. Note that in both cases the prices drop for me and stay the same for the farmer by cutting out middle-men: the shippers, the grocer. By your terms, those are the market makers, and while they make produce commerce more convenient they're certainly not reducing costs for anyone. They're taking profits out of the parties on the two ends of the transaction. I'll grant you that, in my example, the middle-men provide an essential service by giving me access to produce that is not produced locally, and by making that access more convenient. Neither of those apply to the financial markets though: as purely information-driven markets, they're accessible 24/7 from anyplace in the world. So again, what value are the market makers actually providing to the buyers and sellers of financial products?
- maxerickson 13y ago
  Fair enough, the words about cheaper are arguable. I wouldn't want to try to buy bananas in a world where there was no one willing to take them off the truck and hold them for a few days though. As far as financial markets, reliable prices are worth something (even though a reliable price is 'just information'). I agree that in heavily traded instruments, providing liquidity becomes a fairly abstract value, but if you are a large institution, having someone that will readily purchase enormous amounts of shares is a valuable service. For a lightly traded instrument, being able to sell it is also a valuable service. I don't see enormous value in having lots of people spending lots of money chasing pennies, but I have trouble getting worked up about it. I suppose what it comes down to is that I am skeptical that rules designating who gets the tiny bit of slop available in financial transactions will be any more fair than the present system (where various HFTs are competing for the slop, often by essentially offering some of it to the parties in the transaction...).

ig1 13y ago

You seem to be confusing a few different things here. One of the fundamental purpose of a market maker is ensuring that both the supply and demand sides are capable of transacting when they want to, even if the supply and demand side don't necessarily want to trade at the same time. So say the farmer only wants to sell bananas on a Monday and you only want to buy them on Thursday, so you can never do the transaction. So your grocer by buying the bananas when they're available and selling to them when you want them is in fact taking on some of the role of a market maker. The reason that bananas don't need high-speed market making however is that the underlying supply and demand for bananas is pretty stable (I'm just guessing here; I don't know anything about the banana market). With currencies the supply and demand is in constant shift, everything from news events to someone making an online purchase in a foreign currency contributes to the shift. So a large part of the premium you pay for currencies is to manage that risk of the underlying supply/demand shifting. So by reducing that risk you can have lower premiums. Say your grocer bought their bananas at $1 and was selling them at $1.50, what percentage of that 50 cents do you think goes towards managing the risk that the demand for bananas will collapse and the bananas might not be worth $1 any more ? - I'm guessing none of it because the bananas will likely spoil before the price of bananas shifts that much. Hence reducing that risk is pointless in the banana market. HTH

gus_massa 13y ago

On the other hand, if your local grocery wants to sell bananas for $1.00 a pound tomorrow (because the have no banana today), but you want to pay $1.50 but you need them now (because you have a party), then someone with a scooter and a nearby warehouse can go and find some bananas for you (at $1.50) and replenish the banana stock tomorrow (at $1.00). Probably this business will not work with bananas, because bananas rote, the fuel cost and the time someone has to sit in front of the groceries. It's easier to implement with stocks and bonds.