Academic journal article The McKinsey Quarterly

Remaking Market Making

Academic journal article The McKinsey Quarterly

Remaking Market Making

Article excerpt

The business is becoming commoditized. Can it be saved?

There are some who believe that the rise of new, low-cost electronic securities trading should have killed market making and brokerage -- the obscure tasks of executing securities trades for customers and matching buy and sell orders, whether on the floor of the New York Stock Exchange or on some trader's desk deep inside an investment bank. Indeed, commissions have been slashed and bid-ask spreads have fallen; revenue from trading activities has been volatile. Furthermore, the industry has been tarred by trading scandals that have ranged from price-fixing among NASDAQ market makers to the rogue trader who brought down the 232-year-old Barings Bank.

The conventional wisdom is thus that investment banks and securities firms should abandon securities trading and stick to more attractive activities, such as managing assets and originating securities. Investors have hopped on this bandwagon, penalizing banks that earn substantial trading revenue with low price-to-earnings ratios (Exhibit 1).

But is market making and brokerage really such a bad business?

Our analysis shows that, despite the gloom-and-doom prognosis, its economics are healthy. The old business model, which relied on manual, ticket-based trading and on fat commissions and spreads, will no longer work. But market making can still be attractive for players that use technology to automate the trading process and gain scale. All banks, whether they choose to compete fully or not, should decide how to position themselves.

Market making revisited

Despite all the bad press, the economics of market making and brokerage compare well with those of other core banking activities, such as underwriting securities and managing assets. Over the past 20 years, trading revenue has grown just as fast as other sources of bank income and been only a bit more volatile (Exhibit 2). And despite declining margins, trading revenue has grown even faster in recent years because of the global boom in securities trading. From 1995 to 1999, market making and brokerage revenue grew at an 18 percent clip annually, slightly faster than the overall average revenue for the whole securities industry. At the same time, the trading of securities accounted for more than half of the total revenue growth for some of the largest securities firms (Exhibit 3, on the next spread).

On the whole, margins in market making and brokerage can be just as attractive as margins in other banking activities. Some banks are realizing a return on equity of well over 20 percent from making markets for traditional cash equities, while margins for more innovative products (such as derivatives) or for the provision of trade-related services can top 40 percent. Compare this with the 10 to 30 percent earned in underwriting and asset management.

Historically, trading volumes surged every time the structure and efficiency of markets improved--for example, the 1986 "Big Bang" reforms at the London Stock Exchange and the 1997 order-handling rules in the United States. So the prospects are good: forthcoming regulatory changes--such as the introduction of single stock futures in both the United Kingdom and the United States--will stimulate the trading of securities by increasing the market's efficiency and give market makers more flexibility, thereby improving their margins.

In the United States, NASDAQ's SuperMontage will increase the market's transparency by introducing a quasi-central limit order book in over-the-counter (OTC) stocks. (The SuperMontage will display three levels of orders or quotes on individual stocks rather than just the best bid and offer, so participants will be able to get a better sense of the depth of prices of and interest in a particular security.) The repeal of the NYSE's Rule 390 will authorize the off-exchange trading of all listed stocks, thus boosting the market's efficiency and allowing market makers to match orders internally and to capture both sides of the spread. …

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