Market makers – Exploding the myth

Market makers provide an essential pool of liquidity for investors, yet to many the business is seen as something of a black art. Miles Nolan investigates

The City of London employs many thousands of traders and dealers, but market makers appear to receive little attention. However, their basic function of providing risk capital is a fundamental requirement for investors.

Bulletin board users deride them, and even an old lecturer of mine had a few harsh words to say, but that is largely due to a lack of understanding.

Market makers, once known as stock jobbers, used to trade face to face with brokers on the floor of the Stock Exchange, but the advent of Big Bang and modern technology has changed this. When placing an order with a stockbroker, either electronically via the internet or by telephone, the trade will typically be filled by a market maker.

Over recent months many brokers have moved into the space in a bid to profit from market volatility and the return of many private investors. By providing liquidity, market makers play a crucial part in the activity of the stock market.

The advent of modern technology
The leading provider is Winterflood Securities, a ‘pure play’ market maker founded back in 1988 by entrepreneur Brian Winterflood, but now owned by merchant bank Close Brothers. When launched, the firm made a market in 450 stocks, but this has since soared to over 11,000 instruments. Though set up to trade UK equities, the Cannon Street-based firm is now active in overseas equities, covered warrants, exchange-traded products, gilts and bonds.

I visited their old office several years ago, but the business is now a very different animal. Back then, the room was noisy as traders yelled orders and limits round the room – now the place is much calmer. To a large extent, managing director Julian Palfreyman puts this down to the advent of technology.

Winterflood was one of the first to bring in electronic links direct to brokers – otherwise known as retail service providers (RSPs). This started with an agreement with Kleinwort Benson for what was then known as ‘Best’. Essentially, Winterflood traded smaller companies and Kleinwort would take up the larger stocks. Over time, this was phased out to create ‘Winner’, a product that has since evolved to an in-house system known as ‘Boot’.

When trading with a broker, the price improvements received are down to the RSP link. The market maker can see when a broker requests a price and size in a stock, and at this point the investor typically has 15 seconds to accept or decline to deal. By using RSPs, market makers can trade huge numbers of bargains without the need for constant telephone calls. It is also hugely scalable, so if volumes soar there is little need to add to their fixed cost base.

Relationships are key
In the execution-only market, there are 400,000 trades a month. Selftrade typically transacts 1.2 million trades a year and TD Waterhouse is regarded as the UK market leader. The onus on the broker is to provide the ‘best execution’ price to its client, but the advent of RSPs has left firms such as Winterflood transacting up to 95 per cent of their business electronically. A phone call to the market maker is only needed when dealing outside the normal market size, or when trying to work an order. Over time, most if not all market makers have established their own RSP links directly into brokers.

Winterflood employs 200 people, almost half of whom are traders. It typically transacts 45,000 bargains a day and is ranked number one in principal-to-agent business.

Palfreyman says that ‘though this is a relationship business, it is also massively price driven’. By this he means that brokers have a huge variety of market makers to choose from (see table 1) and that with a duty of ‘best execution’ the best price will always be chosen. By making a commitment to trade even when markets are at their worst, Winterflood has deservedly gained a lot of loyalty.

A day in the life of a market maker
The day typically starts prior to 7am, when Regulatory News Service (RNS) announcements are released. Market makers have to make a judgement call on the likely reaction by investors to news such as profit warnings, bid approaches, contract wins and results.

It is also essential to keep monitoring news as it flows through the day, as well as after hours, when negative stories are often released in the hope that they will be ignored. Some market makers use audible alert sounds for price movements and order limits. Prices go live at 8am and close at 4.30pm.

A simple point junior market makers can suffer from is to forget that when a broker is buying a stock he is actually selling from his book and vice versa.

Risk control is paramount so market makers are typically given a total book exposure and a ‘per stock’ limit – anything over this needs sign-off from management or compliance.

Market sizes differ massively but the market maker can dictate this. Some family-controlled public companies often have a limited free float so spreads can be prohibitive. As Palfreyman argues, this is in no-one’s interest as it deters investors, but typically the market maker will choose the bid/offer price they wish to quote.

They are not fund managers so are not in the business of taking large positions; instead, the ideal situation is to close the day with as flat a book as possible. As is the case when investing – to get too emotionally attached to a stock can prove very costly.

On days when prices are moving quickly, a ‘choice’ price is one in which the bid and offer are the same, whereas ‘backwardation’ is the term coined for when the bid is higher than the offer or vice versa. At this point, all RSPs are frozen to prevent any abuse of the system.

Volumes can vary significantly but the recent biotech boom driven by Sareum saw this AIM-listed stock trade almost its entire shares in issue in one day. It’s the turn made on each of these trades that can generate fat profits.
One market follower says ‘to succeed you need a quick brain and have to think beyond the bargain you are dealing’. So, if an investor buying a stock has left the market maker short, they need to be sure they can deliver it.
When deciding to take up a new stock, a market maker will fax through to the London Stock Exchange a sheet known as a Registration Information Form (RIF). If this is done by 3.30pm they can make a market the following day, which will mean committing an obligation to make a two-way price for at least three months.

Increasing interest
Recent results from Close Brothers confirm that Winterflood has remained profitable, with no loss-making days in the six months to 31 January and adjusted operating profit of £25 million – albeit down 9 per cent.

Such results confirm that good money can be made, and over recent months a number of new entrants have joined the fray. These include WH Ireland, Schneider, Renaissance and Westhouse, while Northland Capital is expected to commence market making next month.

Peel Hunt is a leading player and trades in over 2,000 stocks. Head of market making Iain Morgan says that ‘spreads have come down a lot due to the increased number of entrants’. He also argues that low-cost dealing and rapid order execution mean that private investors get excellent value for money, particularly from those market makers able to offer breadth and depth.

Morgan concurs with Palfreyman that to enter the space it is essential to have a decent level of capital – not least due to the capital adequacy requirements of the FSA. Capital is also needed to help fund bargains on extended settlement.

Veteran market maker Simon Doyle recently set up a new desk at WH Ireland. He believes that, despite the obvious success of the larger players in the market, there is further scope for broking houses to establish a position as a niche market maker in their corporate stocks. He argues that, in theory, they should know more about the companies they trade in than their opposition.

Doyle says many corporate clients that trade on AIM cannot understand why their brokers do not make markets – not only does it raise the profile of the broker and its corporate client, but a successful desk should also enhance revenues. Another point at WH Ireland is its ability to offer larger market sizes than the incumbents, a move that helps attract additional business.

Trading platforms
Until the late 1990s the London Stock Exchange was a quote-driven market with all prices set by market makers. Though this still takes place, a system known as SETS (Stock Exchange Trading System) was launched. This allows one to place buy and sell orders directly onto the system, cutting out the middleman.

Winterflood has its own software system, while many smaller players use Fidessa or Proquote to transact business. The ‘yellow strip’ quotes the share price, and below this the market makers that are active in the stock – this is also known as Level 2 (see screen on the left) and is available for all order-driven shares.

The order book is typically used in larger and more active stocks and allows the user to see the full market depth, or the quantity of buy and sell orders at certain price levels. By using SETS it is possible to place an order at a price that the investor is prepared to deal at. All blue-chips and most mid-caps trade this way.

Trading in the 160 or so stocks on PLUS is done in the same way as in those on AIM. Indeed, David Abrahams heads up the desk at Winterflood and says ‘we make a two-way price in almost all PLUS stocks and have noticed a significant uplift in turnover over the past two years’. Though liquidity can be less than on its big brother, AIM, the market is home to well-traded stocks such as Ascot Mining, All Star Minerals and book publisher Quercus.

Most market makers will have a bank of three or four screens – all linked by a mouse. Technology has helped speed up the process but the STX book has remained a constant in all dealing rooms. This is a printed record of all market makers and their contact information.

Sharemark
The number of companies leaving AIM has fallen from 274 in 2009 to 161 last year. Prohibitive costs are blamed by some as well as poor trading volumes, but when delisting there are few ways to maintain a share-trading facility.

It was with this in mind that Sharemark was set up by The Share Centre in 2000. Sharemark is a simple and flexible trading facility for small-cap companies. Instead of market makers it uses a periodic, auction-based trading facility that trades shares at a single price, thus removing bid-offer spreads. It is order-driven rather than quote-driven so calculates supply and demand in the market, thereby doing away with the need for market makers.

By eliminating the spread, investors can save the profit that would otherwise have been paid out to market makers in quote-driven stocks. AIM-listed Brainjuicer and Share (parent of The Share Centre) also choose to dual-trade between AIM/PLUS or the Main Market and Sharemark, so the market makers view the platform as an additional liquidity pool.

Sophie Douglas, manager of Sharemark, argues that ‘small-cap companies themselves can enjoy the benefit of a working market without unnecessary added risk to their liquidity’.