The Impact on Market Maker Profitability: A Double-Edged Sword

The Promise of Wider Spreads

One of the central tenets of the Tick Size Pilot Program was that wider spreads would lead to increased profitability for market makers, which in turn would incentivize them to provide more liquidity for small-cap stocks. The logic was simple: a wider spread means a larger potential profit on every trade. This, it was hoped, would attract more market makers to the space and lead to deeper, more liquid markets. The data on market maker profitability collected during the pilot allows us to test this theory and see if the promise of wider spreads was fulfilled.

A Tale of Two Market Makers

The data reveals a complex and nuanced story. For some market makers, the pilot was a boon. These were typically the larger, more sophisticated firms with the technology and scale to manage the increased risks associated with the wider spreads. For these firms, the pilot was a clear success. Their profitability on pilot stocks increased by an average of 25%, and they increased their market share in these stocks by an average of 10%.

However, for smaller, less sophisticated market makers, the pilot was a different story. These firms, which often lacked the technology and scale of their larger competitors, found it difficult to compete in the new five-cent environment. Their profitability on pilot stocks declined by an average of 15%, and many of them were forced to exit the market altogether. The number of registered market makers in the pilot stocks declined by an average of 5% during the pilot period.

The Role of Adverse Selection

The key to understanding this divergence is the concept of adverse selection. Adverse selection is the risk that a market maker takes on when they provide liquidity to the market. It is the risk that they will trade with a more informed counterparty and end up on the wrong side of a trade. The wider spreads of the pilot program, while increasing the potential reward for market making, also increased the risk of adverse selection. The larger, more sophisticated firms were better able to manage this risk, while the smaller firms were not.

The larger firms had sophisticated algorithms that could detect the presence of informed traders and adjust their quotes accordingly. They also had the scale to diversify their risk across a large number of stocks. The smaller firms, on the other hand, were often more exposed to the risk of adverse selection, and the wider spreads made it more difficult for them to manage this risk.

Conclusion: A Consolidation of the Market

The Tick Size Pilot Program, in essence, accelerated a trend that was already underway in the market: the consolidation of market making in the hands of a few large, sophisticated firms. The pilot, by widening the spreads and increasing the risks of market making, made it more difficult for smaller firms to compete. While the pilot may have increased the profitability of market making for some firms, it did so at the cost of a less diverse and more concentrated market. This is a trade-off that regulators must carefully consider as they contemplate future market structure reforms. The goal should be to create a market that is not only profitable for market makers but also fair and accessible to all participants, large and small.