In OTC markets, the market maker is a principal trader who buys from sellers at a “bid” price and sells to buyers at a higher “ask” price. The market maker's objective is to make a profit from the bid-ask spread.
Principal-based market making is a basic financial service that provides transaction immediacy to other traders and liquidity in financial markets. Market-making arrangements run the gamut, from rapid anonymous trading on exchanges, to sporadic bilateral OTC trading among institutions, to occasional one-off new issue underwritings.
Specific market trading protocols vary from market to market. In exchange markets, market makers offer to trade when a customer submits an order or requests a quote. An order may be submitted at whatever price currently prevails in the market (a market order) or for execution at a fixed price (a limit order). Limit orders are held by market makers for potential execution when the limit order price becomes competitive.
Institutional investors usually trade large blocks either by trading with an OTC market maker, by trading in an off-exchange order-matching market (a "dark pool") or by dribbling out small orders over an
extended time in a retail market.[2] When a block trade market maker accepts a buy or sell order, it usually negotiates the price with its counterparty, while simultaneously searching for offsetting orders and hedging any portion of the block for which it has no offsetting order.
A conventional secondary market or derivative contract trading agreement between a market maker and its counterparties usually states that the market maker is not a fiduciary in its usual trading business.[3] A different arrangement usually holds in primary markets and secondary offerings for corporate securities, where the market maker is usually contracted to be a fiduciary agent for the seller.
In a primary market for corporate instruments, a market maker buys a large block of stock or bonds from an issuer and sells it to investors as a principal; this process is called underwriting. An underwriting contract may specify a fixed purchase price for the underwriter, with a higher fixed price for investors.
Alternatively, the issue may be distributed on a best-efforts basis, in which an underwriter sells to investors without guaranteeing a price. Unlike most market makers in the secondary market, an underwriter in the primary market is usually a fiduciary working on behalf of the issuer.[4]
A secondary offering is an underwriting transaction in which an investor that owns a very large block of an issue engages an underwriter to resell the block. In this activity, the underwriter is also usually a fiduciary. Thus, while a secondary offering is much like a block trade in size and execution, the contract governing the trading relationship between the seller and the market maker is different.
Secondary Markets: Order-Driven vs. Quote-Driven
Parallel exchange and OTC markets exist for many financial contracts, including securities and derivatives. Small orders are usually organized as exchanges, and market making on them is referred to as order-driven.
In contrast, large block orders of the same instruments are dominated by institutional investors trading OTC. In OTC markets, market making is mostly quote-driven.
In an order-driven market, market makers submit a flow of public buy and sell orders that compete directly with orders from other traders. Other traders may trade directly with each other if their order prices are better than a market maker’s posted orders.
In contrast, in quote-driven markets, a potential trader requests a private quote from a market maker. A quote given is for both sides of the market with bid and asked prices, quantities on both sides and a time limit (perhaps a few minutes) while the quote is good. Then a potential customer can quickly try to solicit competing quotes from other market makers and execute the trade at the best bid or offer.
Trade Execution and Position Management
In order-driven markets, market makers compete to capture flow trading. By flow trading, we mean frequent execution of standard sized orders (round lots) submitted by ordinary traders and other market makers.
Bid-ask spreads are generally quite narrow, due to competition from other traders’ orders and other market makers competing to capture the public order flow. This type of trading commonly occurs on stock exchanges, futures exchanges and options exchanges worldwide.
In quote-driven markets, orders come to a market maker sporadically. Some trading activity is like flow trading, as customers quickly hit quotes for standard sized trades (usually around $1 million minimum) of simple instruments like foreign exchange, or FX, contracts or U.S. treasuries.
Other trades are tailored deals that have negotiated terms. Such trades may involve complex derivatives, large blocks of instruments like corporate bonds, swaps, foreign exchange, repos or forward delivery of physical commodities.
For large trades, a market maker usually tries to assemble a position to prehedge a customer’s pending buy order, or to find another buyer for the position in a customer’s pending sell order, before the initial customer’s trade is executed. An OTC market maker therefore tries to set up both sides of a large or complex order before either side of the trade is executed.
Although this might appear to be like front-running a booked limit order in an order driven market, it is a normal and customary risk management practice in a quote-driven OTC block market.
Market Making in Perspective
In a series of recent prosecutions, the government has implied that a market maker in a quote-driven OTC market should be able to provide the same execution profile for a bespoke block trade as that which occurs for a small round lot trade in an order-driven market.
At the same time, the government has asserted that a block trader’s obligation to its customer is like that of an underwriter in a secondary offering. This hypothetical combination of market-making practices is based on several misapprehensions.
In a quote-driven market the market maker agrees to trade a specified quantity at a quoted price in a bilateral transaction. To do this, the market maker must acquire either orders or inventory in advance, at prices that gives it a chance for a profit on the transaction. Otherwise, the market maker would not transact.
Acquiring large blocks of orders or instruments to sell at a quoted price subjects the market maker to risk while holding the order or position, which must be managed. A market maker therefore prudently acquires orders or inventory and sets prices in a manner that allows itself to manage risk and try to avoid a capital loss. The result may be a price per unit for a large block trade that looks less favorable to the customer than the going price in a round lot order-driven parallel market.
