The following was taken from the Undervalued Dog newsletter. It provides a very basic explanation, and may be of benefit to someone:
Q: People are often talking about price manipulation of OTC BB stocks by market makers?
I don't understand why we need market makers.
A: Let's start with a brief definition of a market maker (from now on we'll use the abbreviation MM where necessary). A market maker is a person or persons who represents an institution that wishes to "make a market" in a particular Nasdaq stock. That is, they wish to buy at one price and sell at a slightly higher price to profit from the difference or "spread". When you are trading on the Nasdaq exchange, you are buying from a MM and selling to a MM. They exist to provide liquidity. In other words, they guarantee that when you want to sell, they'll be there to buy from you, and when you want to buy, they'll be there to sell to you, as long as the transaction price is marketable. This eliminates the hassle of waiting for a buyer or seller to show up when you want to trade. That's the good side of MM's.
Next we touch on the bad side. Many MM's have special deals worked out with brokerages and get paid for order flow, and thus are more inclined to induce panic selling and buying to help themselves make even more money above what they are already making on the spread. This creates above average volatility and may explain why the Nasdaq stock exchange is almost twice as volatile as the NYSE or AMEX. Let's say you want to sell 500 shares of Big Board-listed Micron Technology at 23 1/8 a share. The current market is 23 1/8 bid, 23 1/4 asked. If you put your order in with a 23 1/4 limit and are patient, the specialist in Micron will very likely find a customer who is willing to pay 23 1/4 for your shares. In any case, the specialist could not sell shares ahead of you at that price. But if Micron were traded over-the-counter, your limit order would very likely not get executed unless the market started to move up. As long as the market is 23 1/8 bid, 23 1/4 asked, over-the-counter!
, your order would generate a "nothing done," and market makers could trade ahead of you. How do we know this? By comparing how many investor orders are matched or "crossed" on average on NYSE and Amex stocks with the "crosses" that take place on Nasdaq. The numbers are revealing. On the NYSE and Amex, investor orders are matched in 91.4% and 89% of trades, respectively. Nasdaq's spokesman says the number of investor crosses in its market is 1.7%.
Thus, in 98.3% of Nasdaq trades, a market maker inserts himself between buyer and seller. He isn't there for his health; he's there to bite off 1/8 of a point or more. Those fractions can mount up when you are moving nearly 2 billion shares a week. According to Abel/Noser, average Nasdaq spreads are roughly double those on the NYSE--38 cents versus 19.
Who are the market makers? They include big retail investor firms like Merrill Lynch, Smith Barney and Charles Schwab's Mayer & Schweitzer, giant trading houses like Goldman, Sachs and Salomon Brothers, so-called wholesale firms like Herzog, Troster Singer and Sherwood Securities and hundreds of smaller firms like Ryan, Beck & Co. and Key West. In fact, much of the volume that looks so impressive on Nasdaq is not investor meeting investor but market maker meeting investor or market maker meeting market maker. Actually moving a share from one investor to another may involve not a single trade but several: seller to market maker; market maker to buyer. John Gould and Allan Kleidon in the Stanford Journal of Law, Business & Finance in 1994 analyzed this method of counting volume and concluded that roughly 41% of Nasdaq volume is investor-generated. The rest--59%--is market makers trading among themselves, known as "the churn." Double- and triple-counting volume achieves a couple!
of things. It creates the illusion of liquidity in a stock. It also explains why a single day's trading in a Nasdaq stock may represent a major part of its float. Not a big turnover in ownership but simply trading the same shares several times in the day may have accounted for the bulk of the action. |
