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.

Chart 2: Price setters want to capture spread

In modern stock markets, this works very differently

In a single marketplace, usually the person setting the spread is the person who captures the spread.

However, in today's fragmentated market, with customer tiers in ATSs and bilateral segmentation off-exchange, capturing spread isn’t so easy.

Instead, we might see:

• Our market maker improving the bid and the offer.
• Only to see the first urgent buyer trade with on a different venue that has copied the NBBO. They might even see a trade at a better (sub-penny) price than lit markets are allowed to provide.
• It’s likely that the same thing happens to the next market (sell) order, too.

In this case, our market maker, who sets the price (which has protected both of the trades already done, even those off- exchange), has still NOT seen a trade. That means they have provided a service to the market, but still not captured any spread. 

Moreover, their chances of capturing spread are falling as offsetting trades are being matched elsewhere, leaving the market more likely with a residual imbalance. 

Eventually, a trade will arrive that doesn’t get matched before reaching the exchange – either because it is “informed” or offsetting orders are exhausted, as we show in Chart 3:

• A third order fails to find matching trades in other venues and hits the advertised (lit) bid.
• This creates a long position for buyers, as the market falls.
• Rather than spread capture, the price setter now has a (long) position at a mark-to-market loss (adverse selection).

Chart 3: In a segmented market, spread capture may go to the spread setter

This market structure is far less rewarding for the market maker or any investor trying to save crossing the spread. They wait longer and suffer adverse selection more. 

And yet current data suggests this is exactly what is happening. More and more traders are moving off-exchange, using orders pegged to the NBBO. Thanks to the fact that segmentation on other venues creates higher profits for off-exchange trades, those venues often also charge higher prices for trading.

Rebates offered by some exchanges are one of the only ways for exchanges to account for the extra costs of being actionable on a lit and fair access market.

This is an important market structure question

Although this is a theoretical discussion, it is an important market structure question to answer — especially if we want to attract competition for quotes:

• Most would agree that the NBBO is important, and having it saves investors from higher trading costs.
• So, it’s only fair that the trader setting NBBO actually gets to capture spread.
• Or at least earns some economic benefits for providing an NBBO that others use.
• One way to do that would be to provide an economic incentive to be a market maker. Ironically, the frequent push for “free” data in many countries is doing the opposite.

Anything else doesn’t seem fair — or equitable.