What does selling liquidity mean?

Discussion in 'Order Execution' started by elitetradesman, Oct 19, 2011.

  1. I read somewhere that market makers make profits by selling liquidity. What's that mean?

    Also, is it a low risk low return strategy?
  2. ASE1245


    A market maker offers depth and liquidity when there is none. They hope to make a small profit on each trade to what they consider fair value. The term "selling liquidity" I've never heard. In addition, there is a cost to offering liquidity. Besides the time and cost of being a regulated broker dealer, on most exchanges there is a cost from payment for order flow (PFOF). The orders you route to the exchanges from retail shops like Interactive Brokers, E-trade and TD Ameritrade etc, receive money for routing that order to that exchange.

    So, saying that Market Makers sell liquidity is not correct. Market makers pay for the right to offer liquidity through PFOF.
  3. Occam


    I think what the OP is referring to is "adding liquidity", which is indeed what market makers do. But you don't have to be a broker/dealer to add liquidity on most modern exchanges (although there are usually significant advantages given to officially designated market makers), nor does it necessarily cost anything -- indeed it may even pay (generally an amount very small to most customers, but no doubt important to large HFT operations such as Citadel, Tradeworx, or the Timber Hill division of IB). The individual exchanges' Web sites give much information on this topic.

    Payment-for-order-flow takes various forms, but I see the term most commonly refer to the practice of broker/dealers giving the right of first refusal to a market making firm, which does indeed cost the market maker some money (I think it's about $.001 per share). I have no doubt that the cost to the customer is far greater (otherwise, why would the PFOF firm pay for it?) -- the broker really should send all orders to a true, competitive exchange to give the client the best execution, in my opinion. This remains a hidden cost to the customer and allows many "discount" brokers to offer lower stated rates than they would otherwise charge. Yet the customer is still paying in the form of worse execution prices, on average.
  4. ASE1245


    I was referring to the option markets. I'm not sure which he was asking about. Option PFOF is very high. Can range from .25 to .65 a contract. If he was asking about equities, I don't know what they pay for order flow, just that they pay for it.