But the Stock Exchange decided to move to an order driven system where buyers

But the stock exchange decided to move to an order

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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
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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
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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
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