E-commerce will likely mean the end of market makers
Extremely high volatility in financial markets has raised stock market reporting to the top of most newspapers, TV news, and even internet media in recent weeks. And almost every time a reporter starts talking about the most recent rise or fall in the market, a video or image pops up of an intense looking man holding a tablet-like device with a number of monitors behind him. This is the iconic market maker or ground trader of the New York Stock Exchange. While we’ve seen this person probably thousands of times, few can really explain what this person does or why they are still needed in the age of e-commerce.
The NYSE was formed in the early 1800s as a central place for investors to buy and sell securities. Back then, securities were bought and sold in the form of an auction, where a particular stock or bond was put up for sale at a certain point in time and traders bid on it. Professional traders of these securities bought a physical seat on the exchange where they literally sat in an assigned chair and would participate in the auction.
In 1871, the buying and selling of stocks moved from an auction format to continuous trading – any stock could be traded at any time during the trading day. However, to trade stocks directly on the NYSE, you had to be a member of the exchange, which meant buying a “seat”. Purchase prices for this coveted seat ranged from tens of thousands to millions of dollars. The seats were valuable because for decades they were the only ones who could buy and sell most stocks on behalf of investors.
As the NYSE evolved, these ground traders became market makers in particular stocks. These are the people you see on television today. A market maker is someone who facilitates the trading of a stock by constantly displaying the price at which they are willing to buy or sell that security. For example, the market maker may broadcast that he is ready to buy 1,000 AT&T shares at $ 29 per share. Any other AT&T stock market maker can then sell that person 1,000 shares at that price. Historically, these trades were done with manual signals and completed with a nod of the head and the display of his trader number, which is why many market makers were tall people who could easily see other traders and be seen by their colleagues. But today orders are recorded electronically, which is why the market makers you see on TV are wearing these tablet-like devices.
Market making can be a risky activity, as other traders or investors may have information that affects a stock before the market maker can adjust their prices. However, market makers try to limit risk by agreeing to buy or sell only a small number of stocks at a given price. They are also able to make money by buying stocks at a lower price than what they are selling. This is called a bid / ask spread. Before computer trading, the bid / offer spread was quite large for most stocks and market makers made huge amounts of money just on this spread. Today, the bid / ask spread is often a cent or two, which has drastically reduced market making income.
Without a significant bid / ask spread, market makers today rely on the flow of trade to make money. By seeing who is buying a particular stock and how the stock’s price is moving, an experienced market maker can position their inventory of that security to take advantage of that information.
But with the rise of computerized and programmatic trading, many people in the financial industry are wondering if physical market makers in a centralized exchange are still needed. The NASDAQ exchange, for example, does not have a physical location where transactions are executed. Instead, market makers post deals and deliver them electronically where traders can buy or sell stocks over a secure network. Even with stocks listed on the NYSE, the majority of trading is done electronically. So while market makers who gather around a trading post can make a great photo for a financial article, they may not be around for very long for us to see. ??