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April 30, 2002

The Essential Role Of Market Makers: Market makers are highly-informed and agile facilitators of ca

By Wayne Wagner

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  • The Essential Role Of Market Makers: Market makers are highly-informed and agile facilitators of ca

Love them or hate them, institutional traders still need market makers.

It is a relationship built upon mutual need: Searching for liquidity, bringing companies to market, providing research, referrals and soft-dollar services.

Sure, traders, in this love-hate relationship, suspect that dealers take advantage of the sensitive information they provide. It is a practice that triggers adverse price movements, they argue.

Despite the criticism, market makers have an essential role. Think of it as a game of poker. A player knows his own cards and strategy. He needs two skills to consistently win: an ability to assess the other player's strength, and to disguise his own strategy.

A similar cat-and-mouse game occurs in institutional trading. To be sure, a buyside trader knows his cards: the size of his proprietary trading interest and the intensity with which the portfolio manager wants his trade completed. However, the trader doesn't know how much of the manager's information is shared by others. He doesn't know what alternative viewpoints motivate other traders in the market. Using the best strategy in response to these four interacting knowledge sources distinguishes the successful traders.

Poker and trading strategies try to boost winnings by releasing as little information as possible. Traders do this in steps: only a little information is provided to gain reciprocal information or liquidity. This approach has several advantages akin to good poker playing: It hides the size, preserves maneuvering space, and gathers tips on the soundness of the information provided by the trader's manager.

This trading strategy only works when the information edge' the strength of the poker hand is retained. That is, when the institutional trader knows something the rest of the market doesn't. Once other participants discover the information or begin to react to the tell-tale footprints of active trading, the slow-and-easy strategy becomes self-defeating.

Opportunity costs grow as the price moves away before the order is completed. An inexperienced trader may not realize the hand is tipped until completing the order at an attractive price becomes impossible.

The trader knows through experience that he needs to protect the information edge against same-side traders or frontrunners who might be alerted through the market maker. Thus information will be revealed to the market maker only when it suits the purpose of the trader. When the trader is ready to call on for-hire liquidity, the constraints on the market maker will be loosened.

This masking behavior, where real trading intent is not shown, creates latency: Supply and demand are hidden because it isn't safe to reveal the information to prying eyes. From the market's perspective, prices move at a pace set initially by information traders, then often accelerated by inside-the-box endogenous traders. Doesn't sound like a random walk, does it?

Economists call this a Prisoner's Dilemma. The best outcome for all could be achieved if all traders revealed their intentions, although each trader is better off not revealing his hand. The result is a sub-optimal marketplace that generates excessive search costs.

Zero Cost