But the Stock Exchange decided to move to an order driven system where buyers and
sellers are matched automatically, and reasonably efficiently on-screen:
Idea was to cut out the middleman, making it cheaper to trade in London
However, for the shares in the smaller companies, volumes simply aren't high enough
trade to make the order book work:
Seemed sensible to keep the market makers in place, rather than wait days or
even weeks to match buyers and sellers in some of the more illiquid small caps
For market makers, it means keeping a small supply of shares in each of the small
companies they trade
Banks stand willing to “make a market” any time it is requested by a client:
The bank will quote a client a bid or offer price for the securities the client wishes
to sell or buy
The market maker tries to make money by capturing bid-ask spreads:
Buy securities at the bid price and sell them at a higher offer price
The risk involved in capturing bid-ask spreads depends on the liquidity and complexity
of the security
Let us look at two examples
6
Market Making – The Ideal: Riskless
and Unsolicited Transaction
A high yield bond salesperson gets a request from a pension fund manager that wants to
sell $10 million face amount of ABC Corp 8% bonds due June 2020
Simultaneously, a bond portfolio manager at an insurance company calls another
salesperson on the same desk. He wants to buy $10 million face amount of the same ABC
Corp 8% bonds
Both salespeople tell their clients they will quickly check the price, put them on hold,
and yell over to the trader who handles high yield energy bonds
The trader will have been following the bonds and adjusted his view of the appropriate bid
and ask prices many times each day based on tracking reported trades in the market, the
current yields of treasury bonds, the price movements of high yield bonds generally on that
day, and any sector or company-specific news which has recently come out:
The trader tells the salespeople to quote the pension fund a bid price of 91.25% of par
and quote the insurance company an ask price of 91.75% of par
Both salespeople relay the prices to their clients, and both clients immediately agree to
the trade at the price quoted to them
The desk books a purchase of $10 million bonds at 91.25% and a sale of $10 million
bonds at 91.75%
The two salespeople and one trader just earned the desk a $50,000 profit
7
Market Making – The Ideal: Riskless
and Unsolicited Transaction
The transaction turned out to be riskless, but the bank actually had to take substantial risk
in order to get the business
While the clients had equal, offsetting, simultaneous interest in the bond, unlike the bank,
neither of them was obligated to go through with the anticipated transaction:
Either of them could have changed their mind after hearing the price, or might have
called three other investment banks to ensure they got the best price possible
If the bank in this example was “best bid” of three banks quoted by the pension fund, but
