In my many years working in foreign exchange markets, I have seen many innovations that shattered business models and changed the way things are done. One truth that I still consider to be relevant is the distinction between the role of an agent and that of a market maker. Agents are incentivized to maximize a customer’s welfare because that is how they make the most money. Market makers are incentivized to learn as much as possible about how markets function, and about the various strategies of market participants (including their own customers), so that they can use this proprietary intelligence to their advantage by being smarter than the next guy. Or in other words: An agency broker makes money charging a fix fee for best execution; a market maker makes money from the bid/ask spread by internalizing the order flow. You can imagine my surprise as I came across a marketing pamphlet of one of the largest banks in the world that seemed to have melded the two roles into one
There are Friends and Enemies, but no Frenemies
In its brochure, the bank claims to be able to fulfill the role of being both an agency for a customer and a market maker. An agent/market-maker-hybrid sounds to me like something straight out of Dr. Frankenstein’s laboratory. To illustrate the inherent lethal conflict, let’s look at key elements such as order creation, order execution, and order completion.
Order Creation is always an exchange of information. When working with an agency, I reveal proprietary information because I want to empower my agent to do the best possible job on my behalf. If the agent is also a market maker, I reveal proprietary information to an entity whose sole competitive advantage stems from the aggregation of such and other market data. While the bank claims to keep customer order flow information that is used for price setting, separate from private information that is revealed by the customer as part of the order creation, I have my doubts that this will work.
Order Execution for a market maker means to make money from the bid/ask spread by internalizing the order flow. The size of the spread is in direct correlation to the quality of market intelligence gathered: The more accurate and all encompassing, the better the market maker’s strategic position. This includes the scenario when a large order is split into several smaller orders. If an agent is used for this kind of order execution, there is no conflict. Only the agent knows the true deal size, the market doesn’t and therefore responds authentically to each sub-order. This is not true, if a market maker fulfills both roles. The only way for a customer to ensure favorable order execution in this scenario from a market maker, is to have multiple market makers compete for his business.
Order Completion in an agency model includes the disclosure of liquidity pools and prices. It will be very difficult to obtain the same level of detail from a market maker that one routinely gets from agent brokers. Even if a full report is provided by a market maker, it stands to reason, that the information that I as a customer provided initially, will have ended up in the overall market assessment of the market maker. Again, an entity whose sole interest is to take the best price action so that it can be compensated for taking the risk of warehousing market risk. It’s a market maker’s rationale for existence – information gathering in order to make revenue-enhancing decisions.
In conclusion, without being able to truly fuse the two roles into one, the bank hides the optionality it retains in every execution behind sleek marketing terms. Since the executor is the beneficiary, there should be no doubt how the dice roll.
Plurality of Market Makers And Liquidity Pools
I don’t want to belittle the quanundrum this bank is trying to tackle. I mind the length it goes to to hide the inherent conflict behind marketing slogans and wishy-washy language in an attempt to lure customers.
Integral is a full believer in an agency model and through its multi-sided trading networks offers a plurality of market makers and liquidity pools with full auditability.
Clarity in words and transparency in action always wins when state-of-the-art execution of customer interests and elegant algorithmic strategies muddy the waters.