When you learn about financial markets, you get to hear some everyday words used in incomprehensible ways. Like credit or short or stock or derivative. There are two terms that you don't hear too much unless you work with "the markets", but are very integral and precious to anyone in the markets - market making and price discovery.
Market making
I didn't quite understand the term when I first heard it in class. It only sank in when a trader told me "this bond is not very liquid, but I'm trying to make a market in it". He was literally "making" a market, by calling up a lot of people and asking if they want to buy or sell that bond.
We are of course used to market makers - the bhajiwaala who buys off the farmer/other middle man and asks people if they want to buy off him. The broker who connects house buyers and sellers. Shop keepers, malls, etc. Even the advertising agency that informs you of products that are available - thus introducing the sellers with the buyers.
The costs of a market maker are the time spent in this activity, the risk of not being able to sell his stock at the right price (if he buys outright without assurance that someone will buy from him) and other incidentals like renting a physical space convenient to buyers and sellers, transportation costs of bringing things from the seller to the buyer. Payment for this takes many forms - brokerage, commission, agency fees, etc. This cost has to be covered by the value created. In other words, it is only worth creating a market, if the additional value creation is higher than the costs of creating that market. For instance, if a basket of oranges gets a price of 20 rupees in the village and 80 rupees in the city, it is worth bringing it to the city if the transport cost + your opportunity cost (of doing something else with the time) is less than 60 rupees.
Middle men are a much maligned lot. Sometimes justly. But if it was not for the middle man, value would never be created. Supposedly, Bill Gates bought DOS from Seattle Computer Products for $50,000 (at least, that is what the movie Pirates of Silicon Valley said) and made millions of it. Did Seattle Computer get cheated? Did IBM and other companies that bought DOS? They all made money from it, including the end users of those computers - and they made money because Microsoft made it possible.
Price discovery
Price gets confused with worth often. But while the worth of something may differ from person to person, the price is the same all across the market. Theoretically, the price is that point at which you can match the most number of buyers and sellers - because that is when you also maximise value. In other words, if 3 buyers think a basket of oranges is worth 60, 50 and 40 respectively and 4 sellers think the basket is worth 30, 40, 50 and 60 - the price will be set somewhere between 40 and 50. A price of 60 will get you one buyer and 4 sellers - which is only one transaction and maximum value of 30 (the seller valuing the basket at 30 sells to the buyer valuing at 60). A price of 30 gets you 3 buyers but only one seller -and again, the maximum value created is 30, in one transaction. But a price of 40 or 50 gets you 2 buyers and 2 sellers each. Maximum value created: 60 + 50 - 30 - 40 = 40.
Getting the price right is very important to every market and every market maker. The best markets are the most responsive ones, that can adjust the price as soon as they realise that there are most sellers or more buyers. When prices are wrong, a lot of value is destroyed and the markets can also become dysfunctional. When food gets subsidised, for instance, there are more buyers than sellers in the market. Suppose the price of oranges was fixed at 30, in the previous instance. Only one seller but three buyers - which means 2 buyers have to go empty handed in spite being willing to pay higher than the market price. There is no incentive to the other sellers to sell their oranges, even though there are buyers willing to pay their price.
Price is even more important to people who "take risk on their books". In other words - people who buy the products before re-selling them. For them, guessing what they will be able to re-sell at is what determines if they will be making any money that day. Or eating a lot of oranges instead.
Market making
I didn't quite understand the term when I first heard it in class. It only sank in when a trader told me "this bond is not very liquid, but I'm trying to make a market in it". He was literally "making" a market, by calling up a lot of people and asking if they want to buy or sell that bond.
We are of course used to market makers - the bhajiwaala who buys off the farmer/other middle man and asks people if they want to buy off him. The broker who connects house buyers and sellers. Shop keepers, malls, etc. Even the advertising agency that informs you of products that are available - thus introducing the sellers with the buyers.
The costs of a market maker are the time spent in this activity, the risk of not being able to sell his stock at the right price (if he buys outright without assurance that someone will buy from him) and other incidentals like renting a physical space convenient to buyers and sellers, transportation costs of bringing things from the seller to the buyer. Payment for this takes many forms - brokerage, commission, agency fees, etc. This cost has to be covered by the value created. In other words, it is only worth creating a market, if the additional value creation is higher than the costs of creating that market. For instance, if a basket of oranges gets a price of 20 rupees in the village and 80 rupees in the city, it is worth bringing it to the city if the transport cost + your opportunity cost (of doing something else with the time) is less than 60 rupees.
Middle men are a much maligned lot. Sometimes justly. But if it was not for the middle man, value would never be created. Supposedly, Bill Gates bought DOS from Seattle Computer Products for $50,000 (at least, that is what the movie Pirates of Silicon Valley said) and made millions of it. Did Seattle Computer get cheated? Did IBM and other companies that bought DOS? They all made money from it, including the end users of those computers - and they made money because Microsoft made it possible.
Price discovery
Price gets confused with worth often. But while the worth of something may differ from person to person, the price is the same all across the market. Theoretically, the price is that point at which you can match the most number of buyers and sellers - because that is when you also maximise value. In other words, if 3 buyers think a basket of oranges is worth 60, 50 and 40 respectively and 4 sellers think the basket is worth 30, 40, 50 and 60 - the price will be set somewhere between 40 and 50. A price of 60 will get you one buyer and 4 sellers - which is only one transaction and maximum value of 30 (the seller valuing the basket at 30 sells to the buyer valuing at 60). A price of 30 gets you 3 buyers but only one seller -and again, the maximum value created is 30, in one transaction. But a price of 40 or 50 gets you 2 buyers and 2 sellers each. Maximum value created: 60 + 50 - 30 - 40 = 40.
Getting the price right is very important to every market and every market maker. The best markets are the most responsive ones, that can adjust the price as soon as they realise that there are most sellers or more buyers. When prices are wrong, a lot of value is destroyed and the markets can also become dysfunctional. When food gets subsidised, for instance, there are more buyers than sellers in the market. Suppose the price of oranges was fixed at 30, in the previous instance. Only one seller but three buyers - which means 2 buyers have to go empty handed in spite being willing to pay higher than the market price. There is no incentive to the other sellers to sell their oranges, even though there are buyers willing to pay their price.
Price is even more important to people who "take risk on their books". In other words - people who buy the products before re-selling them. For them, guessing what they will be able to re-sell at is what determines if they will be making any money that day. Or eating a lot of oranges instead.
5 comments:
There are people, entities which make or try to make market out of nothing.
Best example is how Goldman Sach's made a market of what was termed as most riskiest and dirtiest asset (or loan classes) of sub-prime products. Once the market is created and product has volume, interest and buzz they make commisions out of each selling they make out of it.
Here is the market makers clog the real value(worth) using series of complex products. We all know what happen the Market of an illiquid product is made and flourishes, the market maker makes money, anyone and everyone remotely involved in this market got tanked, shaking the economies and sending jitters accross the planet. So much to do with Finance, commerce and economics.
A bit like the traditional used car-salesman? Or the marketer of junk food? Creating a market out of nothing which in the end destroys value?
I've seen a little of the world you are talking about (sales guys of complex financial products) and I know that they are not willfully out to ruin the world for their personal gain. What they are is ignorant and arrogant. Not much better than outright wickedness of course, but I like to blame people for the right crime.
Also, what a lot of people forget is that the buyers of these products were also supposedly smart guys who should have understood the complex financial products they were buying. If a fruit seller gave you a closed basket and assured you that it was a product you liked, would you buy it? If you don't know what you are buying - stay away. Don't take a loan when you don't understand interest rates, don't buy mutual funds or invest in shares when you don't understand risk and return.
Anyway, the broader intent of these blog posts is to talk myself through all the things I've learnt in the last few years and try to distill them down to their first principles. I stayed away from financial markets on purpose because they are a lot more complicated. I'm talking of commerce (as opposed finance) - which is the everyday trade of goods and services.
A lot of what you spoke of is part of what I mean to write in the part - liquidity, mistaken valuations and the concept of risk as a liability.
One clarification (before someone else points it out) - when I say I'm not talking of financial markets, I mean to say that is not the bulk of the subject. I worked in financial markets and that is where I draw most of my learning from. But I'm trying to look at the broader principles than just financial markets.
Yaa true and false. Sales push a product and make up a need of that product overwhelmingly necessary than the actual need.
So when I see those sales calls asking for personal loans or a credit card or any other product every other day, one day or the other ignoring of the risk they do purchase it. The same does happen in the bigger market, the crowd follows each other as it grows and smart stop using brains just to keep up with the market.
Funny but the human psychology plays a bigger part than smartness to say off.
Interesting thought that - are people buying a credit card, or buying peace from a pesky telemarketer? That is part of the purpose of this exercise too - understand that the value you derive may not be what it seems. Once you identify what the value is, then you can compare it with the cost and see if it is worth it.
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