U.S. Treasury Securities

Market Making

leave a comment »

Market Making

A market maker is someone who stands ready to buy and sell an asset in a marketplace. By their willingness to provide a two-way market, buying and selling, the market maker serves as a provider of liquidity.  They “make markets” by bidding to buy securities for a little less and offering to sell securities for a little more. The difference between the offer and bid is called the “bid offer spread,” or more commonly, the Spread.

Market Maker
 

Prices, Spreads and Risks

A market maker must be an expert at the asset they are trading. They must constantly estimate in real-time what the fair value for the security is. If they know what it is worth, they can bid a little lower and offer a little higher off this base fair value price. If they are right, they will make a small profit on each trade.

Though simple in concept, this is much more complicated and risky than it sounds, especially in the U.S. Treasury markets. Treasuries are highly competitive and liquid, with thousands of market participants and hundreds of billions of dollars traded every day.

There are hundreds of market makers that provide liquidity. If a market maker has too wide a spread, that is, it bids lower and offers higher than its competitors, the likelihood of doing a trade is poor. His clients will just do business with another market maker with better pricing. And in this very competitive business, with lots of players trading the same identical Treasury securities, the market maker with the better price typically wins.

If the spread is too narrow the market maker may win the trade, but derive too small a trading profit to compensate for the incurred risk, or even worse, lose money on the original trade because his assumptions were wrong. This can easily happen. For example, if the trader’s fair value estimate is just a little off, he may be over paying or under selling the security as to what it is worth. In effect, he would have just locked in a loss.

Even if the trader was good at estimating the fair value of the security and had a tight enough spread to win the business, he is now exposed to interest rate risk. After the trade, the market maker may be long (own) or short (need to borrow) the security. Interest rates are volatile; they move up or down constantly during the course of the trading day and potentially even larger movements over time. These changes are triggered by news, economic announcements and events, market sentiments, general supply and demand and many other factors. Unfavorable interest rate movements can easy wipe out the small trading profit on the original trade.

Example

The 5 Year Treasury frequently trades with a spread of a quarter, that is, ¼ of a 32nd of a percent. Mathematically, this is equivalent to 1/128th of a percent, or about $78.125 per million ($1,000,000 x (1/128) x (1/100)).

Assuming the trader is perfectly accurate on the fair value price and bought $1 million of the 5 Year Treasury, then he would expect to have made an unrealized trading profit of about half the spread, the difference between the bid price and the mid-point of his spread.  On this $1 million trade, he would book a potential gross trading profit of $39.0625. Yes, thirty nine dollars and six cents is indeed a very small number for a one million dollar transaction.

Out of this tiny profit the market maker needs to finance the $1 million dollar purchase price to fund the position. They use the firm’s capital to manage and hold inventory, and must pay for this source of funding. Then there are the direct costs related to the trade, including front, middle and back office costs to book, account for and settle the trade. There are also the many indirect costs and overhead expenses – payroll, sales commissions and bonuses, market data and communication services, systems, trading support, corporate allocations and many other line items.

Trading Profit Versus RiskOn top of all these expense is the market maker’s exposure to interest rate risk on this hypothetical $1 million dollar position. A 1% price movement in the 5 Year Treasury is common. One percent of $1 million face value is $10,000. So if the trader cannot sell or liquidate the position, and the market moves against him, the $39.06 trading profit (before expenses) can easily result in a $10,000 loss. It would take another 250 successful $1 million trades to make up for this one loss.

Lastly, the starting assumption was that the market maker was perfect in his pricing. Instead, let’s assume he was good, but not perfect. Then the average trading profit may be half of perfection, or $19.53 per $1 million trade, instead of $39.0625.  This is a more likely scenario for a good market maker.

As you can see, in the very competitive Treasury market, the market maker’s profits are razor-thin, and the interest rate risk is real and treacherous.

Summary

A market maker’s role is to provide liquidity to the market place for buyers and sellers of securities. For providing this service, they are compensated by the bid offer spread. Market Makers are constantly adjusting prices and spreads and managing risks based on their understanding of the underlying market conditions. It is definitely not a business for the faint hearted.

Advertisements

Written by Larry Ng

October 3, 2011 at 11:31 AM

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s