Struggling to understand the nuances between an exchange and a market maker
Hi,
I am currently reviewing the mechanics of an exchange market (i.e. not OTC) and how a market maker essentially fits into it. And yes, I've heard the standard answer of a market maker: "An MM provides liquidity to a market by and purchasing and selling securities at a designated price". I therefore imagine that when a investor A seeks to purchase a security, he sends an order to his broker, the broker then transacts with the MM (at the price designated by the MM) and eventually the transaction is settled and Investor A owns the security.
This is where the first question arises:
1) An exchange is meant to match buyers and sellers, however, if we have a MM who purchases and then sells securities, surely the exchange does not need to match buyers and sellers as the MM is doing the "dirty work" for them by simply accepting the order? What is the use of the exchange? What am I fundamentally missing here?
Next question:
2) When the broker receives an order from Investor A to purchase Security X, does the broker have an application that gives him an immediate view of ALL market makers' offers, for example GS, JPM, DB, like over the Bloomberg Terminal?
Or, would each market maker have its own 'Platform' where its prices are displayed, so GS JPM and DB display their prices through their own application? If this happens on Bloomberg, is Bloomberg used solely as a means of communication to place orders or are orders actually placed on the terminal?
3) This goes back to question 1. I still do not understand how an exchange performs its function of matching a buyer and seller when the trading desks of the investment banks (i.e. the MMs) basically 'accept' the orders of the broker.
If anyone can help explain what I am missing in understanding this and demystify the process for me, I would be extremely grateful.
SAbru
1. In sake of simplicity,
Exchange: Amazon MMs: Individual sellers Exchange takes 0 inventory risk.
I don't think you can execute a trade via Bloomberg (at least the products a trade) Bloomberg does show the all market maker's market for some products (like swaps)
trading with BB: broker calls multiple BBs. No exchange needed as its mostly OTC. trading on the listed option space: exchange helps matching investors and MMs.
Does that mean if I’m trading on an exchange, like let’s say the Nasdaq, I would send an order to my broker and my broker enters it into the stock exchange ( question: does the Nasdaq have its own separate website for this, that is to send orders and quote prices?) and then the exchange actively looks for MMs that are willing to sell at the order price?
This is most often the case, although some firms have direct market access. Usually market makers, but you don't need to be a formal market maker to get direct access on most exchanges (just have to pay sometimes substantial fees).
Not really. The typical model with exchanges is something called a continuous limit order book (leave aside crossing auctions for now). Traders will quote limit orders, which rest on the book. A limit order basically just looks like this:```` Symbol: AAPL Type: Limit Price: 206.54 Quantity: 100 Side: Buy Lifetime: End of day
Side | Quantity | Price sell 1000 206.70 sell 1000 206.68 sell 300 206.67 sell 250 206.64 sell 100 206.61 buy 100 206.59 buy 391 206.58 buy 24 206.56 buy 100 206.54
Symbol: AAPL Type: Market Quantity: 1000 Side: Buy Lifetime: Immediate
(100 * 206.61) + (250 * 206.64) + (300 * 206.67) + (350 * 206.68) = 206660
Side | Quantity | Price sell 1000 206.70 sell 650 206.68 buy 100 206.59 buy 391 206.58 buy 24 206.56 buy 100 206.54 ```
Hope that helps!
So market makers aren’t necessarily essential to an exchange market, because the exchange just matches according to the trade book you described. Market makers just provide greater liquidity to the system (i.e. place more orders on the order book)
An exchange is just a place to meet at. Think of floor traders. The exchange in the floor. The traders are the bid/ask.
That does not reconcile with the explanation given above and particularly for exchanges like Nasdaq where there is no floor. I am not interested in floor exchanges. There needs to be more about the exchange than merely being "a place to meet at".
Are you stupid? You just had two experienced guys tell you that’s exactly what it is. A place to meet.
The only other thing they do is guarantee trades if firms blow up. But even then they are the third guarantee after firm capital then clearing firm capital.
An exchange is a place where entities can place orders, and the exchange provides a mechanism to hold these orders, and also to match buyers and sellers (the limit order book).
A market is a set of orders in a limit order book for a particular security. An exchange will have many limit order books...one for each security.
Exchanges, at their core, are simply a place for buyers and sellers to place their orders. Recall, the original NYSE was originally just a place under a tree on Wall Street in downtown NYC where traders gathered and traded with each other, until they moved inside a building and got organized. An Exchange allows customers (any entity with direct market access) to place buy and sell orders into their system (whether it be paper tickets, or electronic orders). There are many different types of orders, but lets simplify them into bids and offers.
The Nasdaq has a software platform where traders can enter bids and offers on a variety of securities. Most people use a 3rd party software provided by their broker that connects to the Nasdaq system under the hood, for ease of use. These buy and sell orders get organized into sets of limit order books. An order book is a collection of orders on a particular security. Why "book"....because originally all orders were written down in a book...kindof like a ledger.
Lets take a security like AAPL stock, listed on the Nasdaq stock exchange. To start, there are no bids or offers in the order book....just an empty order book with the capacity to accept buy and sell orders, with tools that allow anybody with a trading account that has Nasdaq access to enter an order.
A buyer might say, i'd like to buy 100 shares of AAPL stock, and i'm willing to pay up to 208, and so he enters into the system a limit order to buy 100 shares of AAPL at 208. This is called a "limit bid order" and it gets placed into the AAPL order book.
Limit - because the trader want to pay a max of 208 to buy the stock...208 is the limit...the highest price he is willing to pay. Bid - because the trader wants to buy, and he is placing a passive limit order to do so. Just like bidding on something in an auction.
Then another trader comes along and say "i'd like to sell 100 shares of AAPL, but i only want to sell it at 209" so they enter a limit offer for 100 AAPL at 209 into the order book.
Limit - because the trader want to receive a min of 209 to sell the stock...209 is the limit..the lowest price he is willing to accept. Offer - because the trader wants to sell, and he is placing a passive limit order to do so. Just like a store owner saying "i have AAPL stock, and i'll OFFER it you for the low bargain price of 209"
The MARKET at the Nasdaq for AAPL is now "bid 208 x 209 offered". No trades have takes place yet...but there is a willing buyer, and a wiling seller...willing if somebody will meet their price.
209 is also called the "ask" because the seller is "asking" buyers to pay his 209 limit price...so sometimes he market is quoted as "bid 208 x 209 ask"
So, an exchange is a platform, where people can place bids and offers, and the exchange provides a mechanism for these entities to do so. Originally, the mechanism was paper tickets, and a ledger type book where these orders were organized. Now, the same basic tasks are implemented with software, but at its core, its doing the same thing..the electronic order book holds bids and offers, and records when somebody crosses the bid/offer spread to execute a trade.
A set of bids and offers on a particular security is referred to as a "MARKET" So, above is an example of a MARKET for AAPL stock (208 x 209), located on the Nasdaq EXCHANGE.
The Nasdaq exchange also has markets for FB, MSFT, GOOG, and every other stock listed on the Nasdaq Stock Exchange.
The Nasdaq Stock Exchange itself does not own any stock. It does not buy or sell stock...it simply provides a place for buyers and sellers to get together (the actual place is now a computer server in New Jersey...and the Nasdaq provides software to clients to connect to its server)...and it provides a mechanism for them to transact trades (called the order matching engine...for when bids and offers have the same price, the matching engine "matches" these orders, and thus they become executed trades). The Nasdaq Exchange is a middleman...it allows buyers and sellers to submit bids and offers, to create a MARKET...and to trade with each other. The Nasdaq charges a small fee to do so...that's how they make $$...they also sell their market data, for a fee of course.
Entities that continually place bids and offers are referred to as "Market Makers" because their bids and offers are what makes a market. Anybody can chose to be a market maker (to submit bids and offers on securities at an exchange)...but to make money at it, you have to be very fast, and its a sophisticated business.
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