Who Deserves to Capture Spread?

We recently discussed how fragmentation undoubtedly adds to competition for venues.

Of course, it also adds fixed and opportunity costs for traders.

However, some of our recent studies suggest it may reduce competition for quotes.

Today, we look at trading economics from the perspective of trader setting the National Best Bid and Offer (NBBO). Our analysis suggests they are perhaps the biggest loser from increasing fragmentation, which, in turn, highlights how the economics of price setting and data use in the current market are quite unfair.

A price setter wants to capture spreads

If we look at how stock markets worked in the 1990s, and how futures markets still work today, trading was consolidated on one venue. In those single marketplaces, if you want to capture spread, you either have to wait until you get to the top of the queue or make NBBO prices better.

Trading and routing are also much simpler in that context: Everyone knows what and where the best prices are — and all traders have equal access to trade at those prices.

One important player in that ecosystem is the trader who sets the NBBO prices, the market maker. Because market makers want to capture spread, they typically:

Advertise a bid and an offer at the same time,
Which helps set the NBBO
And, in a competitive market, tightens spreads.

We show this in Chart 1 below.

The actions of the market maker create significant savings for spread crossing traders and investors.

Chart 1: Price setters tighten spreads and set the NBBO (to the benefit of other traders)

Because a market maker is “two sided,” they don’t profit when a stock price moves up or down (which they call adverse selection). Instead, they only profit from capturing spreads, which requires both a buyer and a seller to trade with them on the same spread.

Conceptually, this works as we show in Chart 2 below, where:

A market maker improves the bid and the offer.
The first “market buy” enters the market and trades with the market makers’ offer (note: for now, the market maker has a short position and risk).
The next order is a “market sell,” which trades with the market makers’ bid (the market makers position is closed and they capture one spread).

Importantly, this profit makes the market maker more likely to rejoin the offer to try to capture spread again.