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How dealers/market makers operate

  • #1
  • First Post: Apr 3, 2011 7:47am Apr 3, 2011 7:47am
Hey guys,

Been trying to understand the fundamentals of FX and all of that and I have now moved on to dealers and market makers.
I was wondering if someone could recommend a book or something that illustrate how they "work". I know about the stop huntings and cuttnig liquidity and all of the easy stuff but would like to move into the harder stuff as to how they operate and manage their inventory.

The idea is that they are on the other side of the coin, taking a short position when you are long and vice versa.. But how do they manage this in a strong trending market? And many say you should not average in or out or whatever, but isn't that the "modus operandi" of the dealers?

I could tell you that I have tried to read TA fallacy and although I respect FTI incredibly much: for the life of me, I dont know what the hell he is talking about..
Some of the stuff is easy to understand, but others are, due to circumstances () partciularly hard to get a grasp of.

Anyway, thank you for taking time guys.
Take care.
  • #2
  • Apr 3, 2011 8:49am Apr 3, 2011 8:49am
[quote=Carnegie;4518093]Hey guys,

Been trying to understand the fundamentals of FX and all of that and I have now moved on to dealers and market makers.

The idea is that they are on the other side of the coin, taking a short position when you are long and vice versa.. But how do they manage this in a strong trending market?


This PDF from a new commercial member sheds some light on how market makers trading on EBS, use other platforms to adjust their exposure.

The concepts of Hitters and Sitters comes in. If you read the PDF a few times, you will see that if a market maker is net short on EBS at the top of a rally because everyone was buying at market. They have to put in BIDS to Buy lower on another platform like Currenex or Hotspot to adjust their position to breakeven or make a few $.

This is the retracement of the bull run that does a few things. Hits the stops of the weak players who bought late in the rally, and allows the market makers who were nice enough to sell to you while the market was rising to adjust their exposure with lower bids , like I mentioned above.
Attached File(s)
File Type: pdf OrderBookFXUsersManual.pdf   1.2 MB | 4,615 downloads
  • #3
  • Apr 3, 2011 10:14am Apr 3, 2011 10:14am
Interesting topic.

I think theres an article floating around somewhere about "trading like a dealer"?

Not sure right now but definetely a good topic to comprehend.

Would it be valid to say they offset their risk by hedging?
  • #4
  • Apr 3, 2011 10:28am Apr 3, 2011 10:28am
http://www.amazon.com/Microstructure.../dp/026262205X

Hot potato model.
  • #5
  • Edited 12:53pm Apr 3, 2011 11:25am | Edited 12:53pm
Quoting eurotrash
http://www.amazon.com/Microstructure.../dp/026262205X

Hot potato model.
Oh man what happened to your avatar that's some scary shit lol

Thanks for the link.. It's on its way

Quoting Carnegie

I could tell you that I have tried to read TA fallacy and although I respect FTI incredibly much: for the life of me, I dont know what the hell he is talking about..
haha join the club!

Quoting seeit


This PDF from a new commercial member sheds some light on how market makers trading on EBS, use other platforms to adjust their exposure.
Oh no not this thing again

Not sure Carnegie maybe this will help... It's prob not quite what you re after but might get your feet wet
Attached File(s)
File Type: pdf chap7 How Dealers Conduct Foreign Exchange Operations.pdf   266 KB | 3,060 downloads
Time hides Nothing
  • #6
  • Apr 3, 2011 2:38pm Apr 3, 2011 2:38pm
Quoting eurotrash
http://www.amazon.com/Microstructure.../dp/026262205X

Hot potato model.
Digest T&E before reading this book.
Living the adventure in my head.
  • #7
  • Apr 4, 2011 1:57am Apr 4, 2011 1:57am
Quoting eurotrash
http://www.amazon.com/Microstructure.../dp/026262205X

Hot potato model.
Thanks euro, you're never short with info! I downloaded it yesterday, going to read it today!

BTW thanks for that one also cindy.. read it a while ago, it's a good raed (the whole one) but Im kinda looking for a little bit more in depth. This only discusses briefly market making (profiting on the spread) and nothing more. But thanks man, its a great read!

So maybe we need to make a discussion instead on the functionings. As I have understood, the dealers more or less are "averaging in" on the trades and are always fading their costumers, right?

Now lets make an assumption. People always say markets consolidate 80% of the time and trend 20% of the time.
That means that 80% of the time market makers are sure to get money (as price oscillates over the same areas) as when it moves down in its range they become net LONG(because costumers are shorting and they have to take the others side).. but as the market moves UP in the range once again, they are in the money with their inventory because it is more or less averaged in. And the process repeats itself (on the upside they're short again)..

But then comes the problem of trending markets, the last 20%. As market moves away on a "fundamental" move (i.e. its backed by fundamentals) then the market makers are screwed because that move actually has real money behind it and isn't going to retrace back.. So they are not going to dump their averaged inventory in the retracement down i.e. they are fucked.

This is the kind of stuff I am looking for and I was wondering if there were someone with some good info out there?

Take care.
  • #8
  • Edited 5:35am Apr 4, 2011 2:05am | Edited 5:35am
[quote=seeit;4518138]
Quoting Carnegie
Hey guys,

Been trying to understand the fundamentals of FX and all of that and I have now moved on to dealers and market makers.

The idea is that they are on the other side of the coin, taking a short position when you are long and vice versa.. But how do they manage this in a strong trending market?


This PDF from a new commercial member sheds some light on how market makers trading on EBS,...

Thanks for the pdf. Are you by any chance an OrderBookFX user ? If so, d'you find you can use their info to your advantage ?
He was looking for the card so high and wild hed never need to deal another
  • #9
  • Apr 4, 2011 10:47am Apr 4, 2011 10:47am
Quoting Carnegie
People always say markets consolidate 80% of the time and trend 20% of the time.
To be honest, I find this one of the worst generalizations of market behavior ever. I find that there is absolutely no truth in it.

Quote
But then comes the problem of trending markets, the last 20%. As market moves away on a "fundamental" move (i.e. its backed by fundamentals) then the market makers are screwed because that move actually has real money behind it and isn't going to retrace back.. So they are not going to dump their averaged inventory in the retracement down i.e. they are fucked.

In Lyons, you'll read that informed traders indeed impose a cost on market makers. This cost is also known as the cost of adverse selection. However, this cost should be (more than) offset by the revenue market makers make from the spread, which is paid by both informed and non-informed traders.

As mentioned, market makers also engage in the passing on of unwanted exposure to other market makers. This is called hot potato trading, and a lot of trading volume originates from this act of market makers managing exposure.

As the process of passing on unwanted position to other market makers, takes time, it takes time for markets to "clear". This could explain the significantly positive autocorrelation of exchange rates on very short timeframes.
The nail that sticks out gets hammered back in
  • #10
  • Apr 4, 2011 11:28am Apr 4, 2011 11:28am
Quoting Noloqy
In Lyons, you'll read that informed traders indeed impose a cost on market makers. This cost is also known as the cost of adverse selection. However, this cost should be (more than) offset by the revenue market makers make from the spread, which is paid by both informed and non-informed traders.
I don't remember if the adverse selection model is based on empirical evidence or not, or whether it applies to certain markets only, but in Osler's paper "Price Discovery in Currency Markets" she finds that spreads are actually narrowest for informed traders, as the information implicitly contained in the informed traders' trades is valuable to the dealer. According to the adverse selection model, the spread should be wider for everyone including informed traders. I can see this being the case at a retail dealer, but a bank which deals with other banks and commercial corporations knows exactly who it is dealing with and whether they are considered informed or not, and can tailor their spreads to suit.

Quoting Price Discovery in Currency Markets
This paper examines the process of price discovery in FX markets. Our benchmark is the standard model of spread determination in equity markets, in which dealers avoid losses to their informed customers by setting an appropriate bid-ask spread. Spreads in this setting widen with the likelihood that a customer is informed. Using the complete USD/EUR trading record of a bank in Germany over a period of four months, the paper first provides evidence that the spreads quoted to foreign-exchange end users/customers do not behave this way. Instead, the evidence suggests that customer spreads narrow with the likelihood that a customer is informed: customer spreads are wider for small trades than for large trades and are wider for the relatively uninformed commercial customers than for financial customers. Other implications of adverse selection are also not supported for this market. We infer that the standard adverse selection model does not adequately describe the price discovery process in FX.

...

The customer-based variation in spreads could also reflect dealers' attempts to strategically gather information (Leach and Madhavan (1992), (1993), Naik et al. (1999)). Dealers may narrow spreads to attract informed customers and extract information from their trades, information from which the dealers can benefit in subsequent interdealer trades. Dealers consider financial order flow to be relatively informative, so this theory predicts that financial customers pay the narrowest spreads, as they do.
http://people.brandeis.edu/~cosler/p...ne-10-2010.pdf (Be sure to read this paper Carnegie.)


Quoting CindyXXXX
Oh man what happened to your avatar that's some scary shit lol
Yeah lol that's me at the end of the day.
  • #11
  • Apr 4, 2011 12:26pm Apr 4, 2011 12:26pm
Quoting eurotrash
I don't remember if the adverse selection model is based on empirical evidence or not, or whether it applies to certain markets only, but in Osler's paper "Price Discovery in Currency Markets" she finds that spreads are actually narrowest for informed traders, as the information implicitly contained in the informed traders' trades is valuable to the dealer. According to the adverse selection model, the spread should be wider for everyone including informed traders. I can see this being the case at a retail dealer, but a bank which deals with other...
Yes, the model is based on the inability of a market maker to discriminate between informed and uninformed traders.

I haven't read Olser's paper, but to me it seems quite difficult to distinguish informed from uninformed traders empirically, even for market makers that know who is on the other side, and even in hindsight.

First of all, there is a game-theoretic element in the interaction between informed clients and market makers. Informed traders desire to hide their private information as much as possible. They attempt to mask their informed trading with the noise generated by uninformed traders. In theory this means that informed traders gradually build up their positions, at a rate that maximizes expected utility.

In case the market maker is able to distinguish informed and uninformed traders, then indeed there are two opposing forces that determine the spread. Spreads could widen for informed traders as they they are the adverse selectors, and they are the ones that impose the adverse selection cost on market makers. On the other hand, market makers may wish to buy their information, by asking a smaller spread. This last point is what you mentioned.

However, up until now we've disregarded position size. It has been empirically shown that for larger volumes, spreads widen (explained by adverse selection costs and MM inventory costs). When a market maker is able to identify informed traders, why wouldn't informed traders request a quote for a massive position at once, instead of gradually adding to their positions, in an attempt to hide their information with the random noise of uninformed traders.

edit: I'm not sure what I'm trying to point out, but it seems to be the following: If informed traders act rationally, then even if market makers are able to distinguish traders, there still there is no free lunch for market makers.
The nail that sticks out gets hammered back in
  • #12
  • Apr 4, 2011 1:20pm Apr 4, 2011 1:20pm
Quoting Noloqy
I haven't read Olser's paper, but to me it seems quite difficult to distinguish informed from uninformed traders empirically, even for market makers that know who is on the other side, and even in hindsight.
There are some simple methods to discriminate: assume all financial players are informed.

Quote from http://dl.dropbox.com/u/190212/ff/fx..._discovery.pdf

Indeed, our econometric analysis indicates consistently that customer spreads are widest for the trades least likely to be informed. Specifically, spreads are widest for the smallest trades and they are wider for commercial customers. Adverse-selection theory would predict that financial customers pay wider spreads than commercial customers because dealers consider financial customers – hedge funds and other asset managers – to be fairly savvy while they consider their commercial customers – firms that participate in international trade – to be uninformed. Empirical evidence confirms the dealer’s perception that financial customers are relatively well informed (Frömmel et al. (2008); Carpenter and Wang (2003)). A negative relation between trade size and spreads has been documented for the London Stock Exchange (Bernhardt et al. (2005)) and the U.S. municipal bond market (Green et al. (2007), Harris and Piwowar (2004)). We are not aware of previous evidence showing narrower spreads for relatively in-formed customer types.

...

In the second stage, the dealer learns whether the informed customer is buying or selling and uses that information to his own advantage.
  • #13
  • Apr 4, 2011 2:30pm Apr 4, 2011 2:30pm
Quoting eurotrash


http://people.brandeis.edu/~cosler/pdf/OMM-June-10-2010.pdf (Be sure to read this paper Carnegie.)
Dya think Osler trades?
Time hides Nothing
  • #14
  • Apr 4, 2011 2:32pm Apr 4, 2011 2:32pm
Quoting CindyXXXX
Dya think Osler trades?
Her husband is an fx professional.
  • #15
  • Apr 4, 2011 2:34pm Apr 4, 2011 2:34pm
Quoting medici
Her husband is an fx professional.
Cool... Must be interesting conversations at the dinner table! If I were a fly I know which wall I'd spend my one week alive sitting on! (Second thoughts... There's a few other walls I might consider first=) -

Wonder if Larry Harris trades
Time hides Nothing
  • #16
  • Apr 4, 2011 2:36pm Apr 4, 2011 2:36pm
Quoting CindyXXXX
Cool... Must be interesting conversations at dinner! - Wonder if Larry Harris trades
Also, she's got plenty of experience from the Fed's fx operation.
  • #17
  • Apr 7, 2011 1:41am Apr 7, 2011 1:41am
Quoting Leonlorenzo
Digest T&E before reading this book.
Link?
  • #18
  • Apr 7, 2011 3:26am Apr 7, 2011 3:26am
Quoting gleem
Link?
You gotta buy that one bud... And I doubt you'd wanna read it off your screen anyway...

Look it up in Amazon "Trading and Exchanges" Larry Harris
Time hides Nothing
  • #19
  • Last Post: Dec 17, 2012 4:01am Dec 17, 2012 4:01am
MMs don't always take the opposing position. Firstly, they balance trades, if one traders buys Euros and antoher sells that balances and MM sits back and gets their profit off the spread. When there are odd trades the MM has to choose whether to trade with or against the trader, and this depends on the market. If they think the market is movinh with trader then they trade with them, collect thier profit and the spread from the trader. If they trade against the same. This is why market making is so risky, if the desk gets its wrong then the company can get a margin call. No wonder some brokers make it impossible to trade at busy times, or maninupulate the spread.
Of course some traders are downright .dishonest and trade against the trader then do everything they can to make him lose.
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