Here’s how the market making business generally works:
Market makers pay exchanges money in return of special trading advantages over everybody else. Then they use these special advantages to fleece the exchange’s other customers (mostly institutional clients).
Retail brokerages can route their clients’ orders to an exchange, to an off-market venue, or to their own market making division. Retail investors still get fleeced… just not on an exchange. Knight Capital Group (KCG) was one of the pioneers in fleecing retail investors. They would buy order flow from companies such as Etrade and use the information to gain an edge.
Sub-penny front running: Suppose you are bidding 100 shares for AcmeGroup at $3.00. You are bidding $300.00 for those 100 shares. A market maker can front run your order by bidding $300.01 for 100 shares. (Then they try to flip these shares at $300.99.) There is little institutional/retail investors can do about this since they aren’t allowed to bid in sub-penny increments.
If you look at the time & sales for various stocks (look at high volume stocks with low share prices such as BAC), you may see trades happening at these sub-penny increments.
Rebates and price improvement add nuances to the front running that goes on. The underlying concept is the same.
Computerized “flash trading” facilitates various tricks that skim a small amount of money from investors. Computers can get into line first because they are faster than humans at placing orders. So, they get in line first and get their orders filled first on the bid/ask spread. On top of that, the exchanges seem to allow computerized market makers to cancel their orders if they are about to get filled. So market makers can line up first on every bid/ask spread even if they aren’t serious about providing liquidity at that moment. If they don’t like an order that tries to take liquidity (e.g. the order size is very large), then the computer will cancel their order and the liquidity-taking trade may not occur. Computerized market makers can also create fake bid/ask sizes.
Market orders have historically been used to abuse investors and there are still many ways in which market orders can be abused. If you have a market order to buy 50,000 shares, a market maker may buy (<=)49,000 shares on the exchange ahead of you and then sell you 50,000 shares at the inflated ask price. (Again, flash trading.)
All or none orders were banned in Canada by the regulators.
But isn’t this illegal?!
I have no idea. The SEC specifically has a rule that disallows retail/institutional investors from trading at sub-penny increments (unless the stock is below a certain price).
Conflicts of interest
Brokerage, market making, and exchanges should probably stay separate companies. Otherwise conflicts of interest can arise such as trading against your own customers. In reality, there is cross-ownership between brokerages, market makers, and exchanges. Goldman Sachs for example is in all three businesses.
To be somewhat fair, one could make the argument that vertical integration creates efficiencies and synergies.
Should market makers exist?
In my opinion, no. They create no value to investors. Some in the industry argue that market makers provide liquidity and an orderly market. The crash of 1987 and the flash crash of 2010 demonstrates that the market making model has failed to create orderly markets. The commodities exchanges have existed for years without market makers and they have done fine.
Value creation in the financial industry
Thomas Peterffy was a pioneer in automating market making with computers. He created value for society by making the financial system more efficient.
Later on he started Interactive Brokers (which later IPOed as IBKR). IB tries very hard to generate value by being an efficient broker. They mail me very little paper and try to automate everything (especially corporate actions) with computers. They have very low commissions and spend very little money on advertising/marketing.
Sadly, the rest of financial industry lags far behind in creating value. Peterffy has some amazing speeches where he tells it like it is:
Regrettably, many chapters of the history of financial markets must be devoted to recounting the myriad innovative and ingenious ways brokers have devised to steal from their clients.
It is unusual to see somebody calling out his industry peers on fleecing their clients.
In general, profitability has gone down. Spreads are much smaller and the decrease in revenue has been slightly offset by higher trading volumes. Regulators will likely continue to curb abuses (and hence profits), though this creates even more rules and regulations. This raises compliance costs for brokerages and exchanges.
Today, the hidden costs of trading are far lower than what they used to be.
Are market makers good investments?
I have no idea. I am too disgusted with the industry to want to research these stocks.
*Disclosure: No position in KCG, IBKR, Goldman Sachs, etc.