A key Goldman Sachs defence in the civil lawsuit being brought against it by the SEC is that the institution was only fulfilling its role as a security market maker.
The firm’s CEO Lloyd Blankfein, for example, told lawmakers in a congressional hearing on April 27 that market-makers had no obligation to tell clients about their own position in a security, and that the nature of the principal business often put them on the opposite side of its own customers.
Many commenters have since suggested the senators’ over-riding focus on how Goldman Sachs shorted a position it was simultaneously selling to clients long reflected a clear misunderstanding of how market-making works.
Of course, that philosophy presumes market-making is a time-honored, legitimate practice.
It also assumes Goldman was fulfilling a purely traditional market-making role.
On the former point it’s worth drawing attention to one of the first key research papers looking into the role of market makers on the Nasdaq. In “Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?” published in 1994, William Christie and Paul Schultz controversially argued that too many consistencies in the depth of security pricing suggested there may have been some collusion going on between market makers on the exchange.
Many academics have since rebuffed the paper, saying it was overly critical. But it does, nevertheless, highlight the fact that concerns about market-makers’ control and influence on the market have been around for years.
Since then, the market has evolved, of course.
A new breed of market-maker has entered the stage: the high-frequency trader and algorithmic market arbitrageur.
The number of specialists obliged to make markets, meanwhile, has dwindled in the face of new competition.
It’s also worth pointing out that banks making markets in ‘modern’ securities like CDOs or ETFs were never obliged to stick around when the going got tough.
In that light it’s no wonder that Goldman Sachs — perhaps the largest market maker in the world — consecutively avoids trading losses quarter after quarter.
That’s because when you’re making markets with no obligation to do so, you are in complete control. You dictate the terms. It’s very hard to lose.
Bloomberg columnist Jonathan Weil noted for example:
Goldman’s chief operating officer, Gary Cohn, this week said his bank’s infrequent trading losses — 11 losing days in the past 12 months — are evidence that Goldman’s traders don’t depend on proprietary trading to generate revenue. The simple answer, he said, is that Goldman’s trading operations “are largely global market-making businesses.
And that’s just one piece of the puzzle. As Janet Tavakoli notes in the Daily Bail on Thursday, (emphasis FT Alphaville’s):
If you want to manipulate a market, deregulate it as much as possible. Then make it as “dark,” and fast as possible. Make it hard for outsiders to view your trades as they get done, and make it even harder for anyone to figure out why you are trading. Get as much monopoly power as possible over the market. Get funding at the cheapest possible rate. The best possible rate is the near zero cost funding available from the Federal Reserve.
Today’s market structure stitched together across a bed of various dark pools, exchanges and security structures has provided more opportunities than ever for the efficient scalping of markets — what people in the business term the arbitraging of small price gaps created by the bid-ask spread.
It happens to be an environment in which an efficient market-maker thrives.
It’s also why banks and proprietary trading firms are increasingly trying to get into the game, especially via securing exclusive arbitraging roles in such things as exchange traded funds.
Low risk, steady return — aka a gravy train.
Related links:
Competition: New entrants seek a piece of the action – FT
How ETFs fueled high frequency trading - FT Alphaville
The market-maker problem - FT Alphaville
Statistical arbitrage and the big retail ETF con-fusion – FT Alphaville