something I always wondered. Why do instiutional bank's fixed-income division sales and trading team always advocate market- making? How do they do it? I mean if the market is one sided and you are the one providing liquidity, aren't you going to accumulate a huge position? Are they always in the market bidding and offering non stop or are they somewhat discretionary as to when to bid and offer?
They hedge their exposure. A one-sided market is only a problem if you don't act on it. That is, if you are accumulating a position on one side then it is a sign that the price is out of whack so you would adjust the price so there's no more pressure. You can also hedge your position. Whether market makers have to make continous market or not depends on the instrument and market. Some are required to make a continous market others aren't.
can you elaborate that? On NASADAQ, there's competing market makers so wouldn't adjusting the price mean less business for you? How would they hedge their exposure?
Yes, adjusting means less business for you, but if the order flow is a one-way train then all market makers would adjust not just you. They would hedge by trading the derivatives (options and futures). The same way option market makers hedge with stocks and/or options/futures.
your assumption is wrong; the market isn't one sided. MM in the otc market is different than in exchange traded securities. Some otc stuff barely trades and its customized to the client...meaning expiration, strikes, amount, etc is not standard. banks will usually provide indicative bids or offers or mids to a client request but are not held to those prices. And those prices are dependent as much on the client's worth to the desk as to the value of the security.
I am assuming we are talking about exchange traded products. The less liquid securities are different.
can you give me an explicit concrete example? Let's say that the market maker is continous. Does that mean he will open a position right after he closes the previous one or once the bid/offer moves, he also posts a new bid/offer? If the market is one sided, say, rallying, would he market make and therefore offer and buy index futures?
First of all, you're mixing up too many instruments. In your intial post you mentioned fixed income desk, then you mentioned Nasdaq, and now you're talking about index futures. As rosy mentioned, there's a significant difference between OTC and exchange markets. Continous means that the market maker has to quote a two-sided market at all times (with some exceptions). A market maker constantly controls his/her exposure and if the exposure gets outside the set parameters the market maker will take some action - for example, hedge or try to offload the actual security by adjusting the quotes. For a good insight into options market making take a look at the "Option Market Making" by Baird.