Value of Market Making

Terry Flanagan

Having designated market makers on exchanges is more important than ever as market structure continues to change.

“Market making is something that is going through a rebirth, especially in light of fragmentation, how market structure has evolved, and from the May 6 flash crash in 2010,” said Bryan Harkins, chief operating officer of Direct Edge. “On ‘the street,’ there’s a lot of talk that market makers really do provide a lot of value, as they have democratized the liquidity provision process. Market makers can improve market quality. Launching market making on Direct Edge and working with our partners is the first step to improve overall market quality.”

The Direct Edge market maker program will launch Jan. 17.

Market makers are market participants that are obligated to quote a buy and sell price for a particular financial instrument, in the goal of make a profit on the bid-ask spread. In exchange, the trading venue usually grants the market maker informational and trade execution advantages. Some venues allow market makers to engage in naked short selling of a stock, or selling it without borrowing it. Historically, on the New York Stock Exchange and the American Stock Exchange, market makers were referred to as “specialists.”

Market making becoming increasingly important for the markets as trading volume is on the decline and as liquidity has been showing signs of drying up. Following the flash crash, the authorities proposed tighter regulations for market makers, in part to ensure that they continue to provide useful liquidity in times of market stress. Among the discussions are incentives that can be provided to the designated market makers. Profit margins for market makers have been declining amid a proliferation of high-frequency trading and the resulting reduction of the bid-ask spread.

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