CANADIAN IR PRACTITIONER PERSPECTIVE

Exchanges such as the Toronto Stock Exchange (“TSX”) and the New York Stock Exchange have designated market makers, formerly known as "specialists", who act as official market makers for a given security. These market makers are selected by the exchange from an approved list; among the firms fulfilling this role for the TSX are BMO Nesbitt Burns Inc., Jitney Trade Inc. and Raymond James Ltd.

The market maker’s primary role is to promote effective markets by providing liquidity and managing imbalances. The market maker is a bank or brokerage company that sells to, and buys from, its clients, quoting both bid and offer prices of a security held in its inventory and seeking to make a profit on the bid-offer spread. 

Historically, market makers stepped in only when a major buy or sell imbalance occurred. They acted as salesmen for the stock, broadcasting through their orders the opportunity to take the other side of the trade and therefore create trading volume within the security. This prevented any one trader, buyer, or seller from pushing the stock too far in any one direction (aka ‘manipulation’) and controlling the movement of a stock’s price. 

Benefit for Both Parties

Proponents claim market makers enhance a company’s liquidity and contribute to the depth and stability of the market by taking a short or long position for a time. A market maker is required to guarantee there is a bid and offer at all times and at an agreed-upon spread goal, ensuring that investors will always have a counterpart to buy or sell from. Some of their actions include:

• Providing a guaranteed fill for small retail client market orders up to a certain amount at the best posted bid or ask price;
• Automatically filling all market priced odd lots; orders that fall outside the standard block of 100 shares. This ensures liquidity for investors who place orders to buy or sell stock in volumes of fewer than 100 shares; and
• Mitigating market pressure in periods of high volatility by absorbing some of the orders, thereby limiting excessive price swings.

Most market maker trading is passive in the sense that when there are buy orders, they are absorbing some of the buying pressure as sellers and vice versa. This creates trading volume and momentum for the security, and provides a source of information on who is buying/selling the company’s stock.

In return for providing liquidity for the company, market makers are compensated by means of price differentials – making money from buying shares at a lower price than the one at which they sell them (the ‘bid/offer spread’). The more actively a share is traded the more money a market maker makes. But this does not come without a degree of risk.

Any profit is basically compensation for taking the risk of holding onto a position, which could dramatically depreciate in value if the market crashes. Because the market maker’s job is to provide liquidity, he has to buy or sell shares even though the rest of the market may want the opposite. As a result, the market maker could be left with either a lot of stock that he paid considerably higher prices for, or be short of stock that he has to purchase at higher prices and thereby realize a loss.

Issues with the Market Maker

After speaking with several colleagues who have also used market makers, two issues emerged: (1) the potential for market manipulation, and (2) their overall effectiveness.

It is often felt by investors that the market makers manipulate prices. In reality, they are duty bound to make a market and to meet the needs of those to whom they are responsible, and their actions don’t necessarily directly impact price. However, market makers may try to influence the market by lowering prices to encourage selling, or marking a price up to encourage buyers to think they have reached the bottom.  

Market makers have unparalleled access to information about buyers and sellers when the firm is engaged by both parties in the same transaction. They also usually know far more about the underlying securities than the clients who end up owning them. This knowledge gap is referred to in the marketplace as ‘information asymmetry’ and is a money maker for an organization that is willing and able to trade ahead of other market participants. And as the 2010 investigation of Goldman Sachs showed, there may be some basis for concern. According to the SEC lawsuit, Goldman took large short positions in deals it facilitated while at the same time actively soliciting clients to go long in the same deal. This is a conflict of interest that provided a huge incentive for Goldman, sharing as little information as possible with counterparties in order to gain a trading advantage.

Secondly, market makers’ presence and support appears to be less influential today, due to the massive trading changes introduced in the market over the past few years. The emergence of automated high frequency trading, growth in ETFs trading, the introduction of alternative trading platforms and algorithmic trading have changed the nature of the market. The volume and speed of trading has increased substantially, and it’s largely untraceable. This has impacted the market maker’s ability to impact the market and provide competitive intelligence to a company. In addition, there are a lot of derivative plays on interlisted Canadian stocks, which muddies liquidity as swaps are written and later unwound, often by the market makers themselves. As a result, fewer companies are actively working with market makers, relying more on their network of brokers and institutional sales professionals.

Working with your Market Maker

Companies should treat a market maker like any other broker, institutional salesperson or investor – but don’t solely rely on a market maker. And never divulge any non-public, material information to the market maker, as you are dealing with professional traders and not insiders.

Turn to market makers when you need to find out more about trading in your stock, and question them about their own trading history. And remember: while they fulfill a useful purpose, in providing liquidity for your stock, they have their own agenda – to generate profit for their firms.