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The last 20 years has seen remarkable change in the equity markets, but not everyone is pleased with the evolution. According to international research and consulting firm TABB Group’s latest research, “Myth Busting and the New Market Maker: Liquidity, Speed, and Risk in an Age of Microseconds,” many investors and market professionals do not fully understand the role of market makers, leading to a number of untrue beliefs.
The research, authored by TABB CEO Larry Tabb, looks at today’s market makers and debunks four of the most pernicious market making myths, including that marker makers provide little liquidity, trade in front of investors (many incorrectly call this front-running), increase volatility and systemic risk, and need artificial structural advantages to survive.
Tabb explains that despite the advent of exchange competition and shifting regulations, such as the implementation of Regulation NMS, market makers have remained the glue that holds markets together. Much of the challenges surrounding market makers stems from large investors requiring greater liquidity than the market is able to supply, which comes at a price that investors are increasingly unwilling to pay and traditional dealers are unable to provide. This environment leaves the job of market making to smaller and more automated players who utilize technology to provide liquidity at very tight prices across many trading infrastructures. It is this mismatch between supply and demand that has made some investors uncomfortable and given rise to these market making myths.
Explaining why myths around market makers are untrue, Tabb says:
Market makers use technology and data to glue together the fragmented execution fabric so it appears seamless. This is not easy as market makers provide liquidity while trying not to get picked off, and not get taken advantage of by other fast traders and investors. While ATSs and exchanges are beginning to create structures to bring parity back to markets by implementing speedbumps and other time-delayed order types, TABB Group doesn’t believe these new structures significantly impact the role of market makers, who will continue quoting, providing liquidity, and facilitating the price discovery needed to make markets efficient.”
As automation augments human traders and new market structure changes how buyers and sellers interact, a new level of sophistication and complexity are created. According to TABB, this complexity will first be mastered by the market maker and they will hemorrhage cash if they get it wrong. As market makers learn how to provide liquidity electronically, brokers and investors will learn how to better take liquidity and regulators will learn how to effectively monitor and supervise this process.