Market Makers and the Art of Liquidity

art-liquidity

The screams of the trading pit have been replaced by the whir of the machine. Photo: Dennis van Zuijlekom

Liquidity is the lifeblood of the economy, it’s the oil that slicks the wheels of the machine powering the world. And when it all came crashing down seven years ago, it was, what else, but a crisis of liquidity.

Though oft criticized—by the likes of Aristotle to the Occupiers of Wall Street—this endless thirst for liquidity is the reason why we have market makers, merchants of exactly that.

Deutsche Bank’s Markets Research team puts it far more elegantly in a 2013 special report titled The Economics of Market Making, citing the branch in physics that deals with complex systems. Market makers are the “emergent behavior” that arise “from the interactions of many agents.”

But while their purpose remains steady, market makers have rapidly and radically evolved over the last quarter-century, a change best reflected by the slow then sudden desertion of the market trading floor, soft bodied humans replaced by hard shelled algorithms.

Within this narrative, the victor between man and machine is hardly a moot point—we’ve already lost to the highest frequency. Soon after the financial crisis, algorithmic trading made up the majority of equities trading volume in the U.S.

And the robots aren’t just omnipresent, they’re incredibly savvy at playing the game. In filing for its IPO last year, Virtu Financial revealed that the computerized market maker had lost money on just a single day over the course of five years of trading.

Market makers exist to buy cheaply and sell dearly.

It’s easy to forget, however, that we also write and rewrite the rules, which is exactly what happened at the turn of the millennium, when new regulations catalyzed the proliferation of dozens of new exchanges, effectively decentralizing the markets.

That’s what sparked the robot revolution. But that revolution is also losing steam, with profits and volumes falling annually since 2009, the result of a saturated playing field and a wiser, evolving marketplace. And then, of course, there’s the one guy sitting at home who allegedly outsmarted the entire army. The industry has begun to contract and consolidate.

Even so, market makers have never been more pertinent as the market grows ever efficient with the world’s wealth funds in constant search for trustworthy liquidity.

And it’s a trend that will likely continue. Today, much of the cost and search for liquidity is undertaken by individual firms and financial institutions. As banking services continue to be unbundled and marketplaces adapt to enable more efficient competition, those needs should increasingly be borne by specialists. After all, back on the exchange, that’s exactly what market makers were called.

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