Who Gets What And Why

Quick Notes

Economics is about the efficient allocation of scare resources, and about making them less scarce.

One way financial markets provide thickness to ordinary traders is by giving certain professional traders the incentive to become "liquidity providers." Members of this group don't plan to hold a security and watch it appreciate; rather, they move fast and act as market makers. They always offer both a bid and an ask on the financial commodity for which they are making a market; that is, they simultaneously offer to buy and sell. Liquidity providers make their money by having a spread between those buy and sell offers, which they continuously adjust as the market moves. The narrower that spread, the greater the quantity they offer to buy or sell at that spread, the better service they are able to provide to whoever comes on the market to make a trade.

But when there are high-speed traders in the markets, LPs are forced to quote bigger spreads or offer to trade a lower quantity to at least partially protect themselves against being 'sniped' by a trader using one of the new superfast lines. Such a trader might be able to buy from them at their old prices (now out of date, or 'stale') and then moments later sell back to them at the new higher prices. The wider the spreads the LPs quote, the further prices have to jump before they can be exploited on both sides of the trade this way, and the more they pass on the cost of protecting themselvs to ordinary investors.