By: Heero Yuy
The other name that we best know for Market Makers is “Middle Man.” Someone steps in the middle to broker (make the deal happen) any particular business transaction of a service or product. Market Making is the business of these Market Makers or “Middle Man” in attempts to provide that product or service to other individuals.
A real estate agent/broker for instance makes a market for those who are looking to buy or sell a home. They do this for a set percentage (%) of the value of the Real Estate being sold and this commission is charged to the seller of the home to be split between the two respective agents (buyer and seller agents).
i.e. A 6% commission split down the middle (3%/3% for buyer/seller agent) for a house sold at $400,000 comes out to a payday of $12,000 for each realtor. On a house that’s worth $2.4 million the same 6% commission for a 3%/3% split would come out to be about $72,000 for EACH realtor!
Key take away from the above example is that the higher dollar item you buy or sell, the larger the commission. Obviously, there is a higher chance of selling more houses at $400,000 vs houses at $2.4 million. Relative success of the Market Makers depend on the volume of goods they sell at a respectable price point and the commission structure for doing the business.
In the stock market the Market Maker buys stock from clients who are looking to sell and then sells stock to clients who are looking to buy. Much of this is done by machines these days but the bid-ask spread is how a stockbroker makes a living. The difference between the buy and sell price is the commission that the stockbroker makes on top of the flat commission fee charged for a buy or sell transaction OR they have a commission per share structure. This topic is explored in many popular culture movies such as:
- Wolf of Wall Street (2013)
- Wall Street (1987)
- Wall Street: Money Never Sleeps (2010)
- Big Short (2015)
- Margin Call (2011)
- Trading Places (1983)
Bankers are simply buyers (Hedge Funds, Private Equity, Venture Capital) and sellers (Investment Banking – think IPO) of business and institutions and it’s credit and debts. For further reading on market making in the stock market please reference Max Dama on Automated Trading. Max works as a low latency algorithmic trader now at Headlands Technologies in Chicago. His piece on automated trading elegantly explains all markets and leads the reader through the history of markets from ancient Bazaars to the modern day algorithmic battlefields of Wall Street.
In inventory control they talk about market making in terms of turnover rates and throughput rates in a manufacturing or warehousing setting. All the pieces that makes the market can be machines (conveyor systems, forklifts, etc) or human operators that puts items into boxes for shipments. In the military it is about: How many rounds can you get down range, how many hits on target, and how fast can you take down the enemy force? Our entire economy depends on this life-cycle of brokering different products or services to different markets at the right price for a fee. Market Makers are essentially salesman. Apple sells phones, Tesla sells cars, celebrities through the canvas of film sell dreams.
Let’s follow that last analogy of being a salesman. Sales has a negative connotation in society because we think about used car dealers or door to door sales man when we hear the word salesman. However, people who sell enterprise software ($200k+ salary), medical devices ($150k+), high-end car ($150-300k), real estate agents ($100k+), and commercial machinery ($100k+) are also considered salesman. What other individuals can be counted in this category of salesman?
Most of us are lead to believe that we have to go to college in order to make a decent wage, then get a Masters (MBA, MS, etc), Doctorate (PhD), become a Doctor (MD) or Lawyer (JD) in order to become successful and revered in life. The product here are the varying levels of degrees/education, the pushers (advertisers and promoters) being journalists that review and rank the relative prestige of these schools, teachers who tell (sell) students this idea as the true path to financial well-being, parents who promote the ideologies of the teacher and journalist as it is well known to them, financial institutions and Federal government handing out money with interest (Student loans) to make this market happen, and then the individual student being shuffled through this assembly line(s) on his or her way to worldly success.
How important we are is gauged by our relative success in how we navigate through this multi-layered market making process and what value society assigns us for our efforts ($/hr, salary/year, etc). Teacher sells ideas and dreams, journalists sell schools and products or services related to the school finding and admissions process, financial institutions and the Government sells student loans (debt), and we as individuals buy it all up with the hope of paying off all the principal, fees, and interest associated with taking this (long) position in the educational process. The (monopolistic) market is made.
We can find salesman or Market Makers in all walks of life using the above vantage point. The priests sell salvation thru religious texts, the rapper sells music, the mechanic sells services, airlines sell tickets for individuals on travel, Sporting events sells entertainment, Social-media sells clout and social acceptance, the news and media sells fear, etc. This can ONLY happen if there is some significant financial upside for the Market Makers. If there were none then we would go back to a non-Capitalistic society that involves clubbing people on the head to eat their lunch (sarcasm).
“Anything worth doing is worth doing for a buck” – Gordon Gekko, Wall Street (1987)
This post explains broadly the process of Market Making and Market Makers. It is crucial to understand this concept as you read future posts so that you can track who is the winner and loser of each transaction (trade) and how much risk each party takes on for doing (brokering) the deal. Knowing the background information on how markets are made will allow you to make better decisions, financially and otherwise, so that you know how to come out on top more times than getting the short-end of the stick! (Positive expected returns or Alpha)