Recently we discussed how fragmentation will undoubtedly add to venue competition.
Of course, fixed costs and opportunity costs will also be added to the trader.
However, some of our recent studies suggest that it may reduce the competition in estimates.
Today we are considering trading economics in terms of traders setting the national best bids and offers (NBBO). Our analysis suggests that they are probably the biggest losers from increasing fragmentation. This underscores the economics of pricing and data use in the current market are very unfair.
Price Setter wants to capture the spread
Looking at how the stock markets worked in the 1990s and how the futures markets now work, trading was consolidated in one venue. In these single markets, if you want to capture spreads, you will need to wait until you reach the top of the queue or improve the price of the NBBO.
In that context, trading and routing is also much easier. Everyone knows what the best price is and where it is. All traders have equal access to trading at those prices.
One of the key players in that ecosystem is market makers, traders who set NBBO prices. Market makers want to capture the spread, so usually:
- Advertise bids and offers at the same time,
- Helps you set up NBBO
- And in competitive markets, it strengthens spreads.
This is shown in Chart 1 below.
Market makers’ actions generate significant savings to spread traders and investors.
Chart 1: Pricingers close spreads and set up NBBO (for profits of other traders)
Market makers are “double-sided,” so when stock prices go up and down (which they call a disadvantageous choice), they don’t make a profit. Instead, they only benefit from earning a spread, so both buyers and sellers need to trade with them in the same spread.
Conceptually, this works as shown in Chart 2 below. Here
- Market makers improve their bids and offers.
- The first “market purchase” enters the market and trades with the market maker’s offers (Note: For now, market makers have short positions and risks).
- The next order is “market sales” and trades with market maker bids (market maker positions will be closed and earn one spread).
Importantly, this profit makes market makers more likely to re-enter the offer to win a spread again.
Chart 2: Pricingers Want to Capture the Spread
