Investing 101: Market Making
Updated: Feb 9
After recently partaking in Amplify Trading’s Finance Accelerator event, I felt compelled to write this article about the lessons I learnt, and the role of Sales Traders and Market Makers in an investment bank. Having hands on [virtual] experience making markets by providing a two-way price to clients was a real eye-opener. But to understand that, let’s make sure we’re on the same page by reviewing the structure of the financial industry.
We Divide Companies into Two Parts – The Buy Side and The Sell Side
On the Buy Side, you have companies such as Hedge Funds, Asset Managers, Pension Funds and Private Equity Companies. Their main objective is to raise funds from investors and invest those funds to generate a return. Now, in order to invest those funds and generate a return, they need to use the services of the Sell Side i.e. investment banks. The Sell Side are selling a service to the Buy Side. For those services, the Buy Side must pay commission and fees.
Overview of an Investment Bank
Generally speaking, an investment bank is split into two parts - Investment Banking and Global Markets. Investment Banking is geared towards providing advisory services for large companies. If a company wants to acquire another company (Mergers and Acquisitions – check our article on them here) or wants to raise money (which you can read about here), they’ll give the Investment Banking Division a call. On the other side, the main objective of the Global Markets Division is to enable clients (on the Buy Side) to buy and sell financial products. In other words, they provide clients access to markets by providing a two-way price (but more on that later on!)
Understanding the Need for Banks
So, you now know more about the Buy and Sell Side, but how do they actually work in practice?
Here’s an example. An Investment Bank Research Team will distribute their research to an Asset Manager or to any Buy Side company who they feel their work could have an impact on. The Asset Manager may act on this research by either buying or selling a particular equity, currency, commodity, derivative product etc. Then, they will speak to their execution trader in order to execute the large trade. However, since the quantity is large, the execution trader will want to outsource the trade to an Investment Bank in order to get a better price than they would have got on the exchange.
Exchanges are marketplaces for the trade of securities, commodities, derivatives etc. Companies such as Trading 212 are trading platforms that give retail traders (people like you and me) access to the exchange.
The Asset manager will contact a Sales Trader who works in the Investment Bank. The Asset Manager will ask the Sales Trader for a price which needs to be better than the price stated on the exchange. The Sales Trader will then ask the market maker for a price for the client to execute. The Asset Manager will pay a commission of around 0.1 per cent for this service.
Making a Price
We’ve seen market makers provide a price, but what actually is a price? A price has two parts, the buy price, and the sell price. This is called the bid/offer spread. What confuses a lot of people is that the bid and offer meaning changes, depending on what side of the trade you’re on.
From the point of view of a Sales Trader in an Investment Bank, the bid/offer means buy and sell, respectively. The Sales Trader will buy at the bid price and will sell at the offer price.
From the point of view of an Asset Manager, the bid/offer means sell and buy, respectively. The Asset Manager will sell at the bid price and will buy at the offer price.
The difference between the Bid and Offer Prices is called the spread. The spread is how much money you would lose if you bought then sold a security or asset straight away. The smaller the spread, the more liquid the asset is. Here, liquid means how easy it is to buy and sell a financial product at any time. For example, a company like Apple has very high liquidity but a much smaller company such as the Ardagh Group (which you’ve probably never heard of) will have less liquidity since there are fewer people wanting to trade its shares. The spread also reflects the associated risk with the trade, in case the trader has to hold onto the security or asset. This would occur if the trader doesn't have another counterpart lined up, immediately willing to take the other side of the trade.
Confused? Well here is a very simple example. Imagine you’re a Sales Trader working in an Investment Bank. Exciting! The phone rings and a client asks for the price of Apple. You check the exchange and Apple is trading at $100. You quote 98/102 (keeping the numbers simple). This means you are willing to buy Apple shares at $98 and sell them at $102. The client decides to buy 10,000 shares for $102 each. So, as a Sales Trader, you’ve just sold 10,000 Apple shares at $102 each.
Great! What next? To make money on this trade you need to buy 10,000 Apple shares for less than you sold them. Buy low, sell high... it’s not rocket science!
The phone rings again and a different client asks for the price of Apple. You quote 97/103. This means you are willing to buy Apple shares at $97 and sell them at $103. The client decides to sell 10,000 shares for $97 each. So, as a Sales Trader, you’ve just bought 10,000 Apple Shares at $97 each. Well done! You’ve made $5 on each. This means $50,000 profit with two phone calls. In reality the spreads are much smaller often around 1/8 (0.125) or 1/16 (0.0625) and the communication is through instant messaging with hundreds of clients all at the same time!