market maker privilege
Friends,
Trader is a broad term. Uselessly broad if it encompasses jobs from the Vanguard employee who sends the rebalance order 4x per year to keep VOO in line with SP500 weights to the oil trader who flies into contested lands to broker cargos to a warlord. The word “trader” flatters a healthy share of W2 earners while underselling big-stakes dealmakers. Trading itself is a business, capable of being traded, bought and sold, while the soldiers within the business themselves are also called traders.
The trading decision to bother at all with this project we call “trading” is more important than the trades you make if you do bother. This is why it’s important to understand the nature of the various careers that count as “trading”.
Market Makers
“Market-maker” is a weird word. The first time I ever heard the alliterative phrase was being asked in an interview to “make a market” on some quantity like “how many McDonald’s are in Philadelphia”.
Eyes just glazed over. Like what does that sequence of words mean? Like you want me to go make a market? Like set up a McDonald’s in Philadelphia? The words did not compute at all.
When I see a Asian HS kid with a swag tee that includes Jane Street’s logo in the sponsorship roll, I promise you that 16-year-old knows what a market-maker is. Times have changed. The job literally pays 21-year-olds the same amount a doctor makes by the time they are in their prime only after not sleeping in their 20s during the institutional hazing period known as residency. It’s the same pool of high achievers, but one group got the memo that being a millionaire by age 27 is better than just starting to chip away at a million dollars of debt if we count in pre-tax dollars.
There’s no twist here. Ball don’t lie. The market-makers have a sweet gig. That’s why it’s hard to get. Also, the kids they hire to become market-makers…well, they’re smarter than you. You can get all triggered and start the whole EQ or “street smart “ song and dance and you wouldn’t be totally wrong, but you’d be wrong. Those kids get hired because they’ve outcompeted many other kids who, unlike in my day, are aware of the job, aware of what it takes to get the job, and really, really want the job.
Now, if your goal is to be financially successful and you found this in any way to be discouraging, then you have told on yourself. Your powers of observation and creativity are holding you back more so than your brains. You’re also a quitter and may not have a claim to even a single original thought. Since nobody in their right mind would surrender to these charges, I assume nobody feels discouraged. We’ll proceed.
The point is, it’s a job with a honed criteria. On average, you must be tall to play basketball. No controversy. But this job of market-maker is just that. A job. You’re not an entrepreneur. You’re not consumer-facing. You aren’t a deal-maker. You’re a polar bear. Adapted to a specific environment. I’m not saying these people couldn’t adapt in another one, I’m only saying that they are specialists, which is a neutral statement.
The job doesn’t require as many hats as one that must constantly interface externally or with clients, suppliers, or investors. You just talk to other nerds and maybe, if you have a Chicago or Brooklyn accent, some brokers.
Which is all to say — it’s a weird thing to fetishize. If you’re going to fetishize a job just because it makes money, what happened to rockstars or center fielders or Scott Disick.
The fetish with market-makers or almost all professional traders is misplaced. Most professional traders have exactly what the dreamers don’t want. A job. They have a job in a system. With a boss. They are highly specialized at piloting that lucrative system, but it’s not their system. A fighter pilot is a decent analogy. You have an exceptional person tuned to commanding a complex, cutting-edge machine. You want a great pilot to maximize its potential. But if we’re being honest, the machine matters more. If you have a 2.5 standard deviation pilot instead of 3, I suspect that doesn’t matter as much as having the best jet. If you’re a market maker whose machine can’t win a race, it won’t matter that you’re smarter than the trader at Jump.
Unless…
You’re not entering the battles or the races where the machine is the showcase. The traders who have the biggest p/l’s don’t necessarily get to keep the most, because they are the same traders who had the fastest plane. Well, a lot of that performance is credited to the tech. The seat.
Since I left institutional trading, I’ve had a chance to meet traders I didn’t think existed. I’ve been paid to simply be a sounding board for people who have more money than they have any idea what to do with. Money piled high by trading for themselves in active strategies. Sums that pods would be thrilled with, but this is personal capital. Those are the traders I’d think would be in the mind’s eye of the aspiring trader. No obligations to investors. Very few or even no employees. The trading versions of Phil Ivey.
[I don’t think I’d be stepping out of turn to share some commonalities I noticed in my conversations with these traders. They were all under 35. They were almost all obsessed, although some were leaving that phase. Having more loot than you can spend in a few generations is probably demotivating to anyone who isn’t a megalomaniac.
Which leads me to what I did not expect…they were all humble. It wasn’t an aww shucks humility. It came across in the way they listened. Sponges. Parsing everything. When I say humility, I mean low ego, as in they didn’t bring assumptions to the way they listened. It felt out of the ordinary and yet they all shared this quality. It left a mark on me. Since meeting them, the absence of this quality is now more noticeable.
Oh, one amusing contrast. There was this recent Pmarca bit where he shit all over introspection, meanwhile, I recall this group of traders being way out on the right tail of introspection and self-awareness. Could be a selection effect as I was approached by a 3rd party about meeting them, so I wouldn’t meet the people who didn’t agree to it.]
Anyway, back to the market-makers toiling away in their getting-paid-like-a-doctor-in-the-80s job. They’re not raising a flag, but by virtue of their academic excellence and persistence, have successfully landed, at least a temporary inheritance, of a lucrative seat. The seat is a legacy from a process I outlined in A Former Market Maker’s Perception of PFOF:
What’s absent from the narrative is how tall the pile of bodies these firms stand atop. I should know. I used to be able to work five hours a day (NYMEX alum holla) and make a lawyer’s wage. And in some years, a law partner’s carry too. Well, if you were smart you saved your money and realized it wasn’t going to last. The days of “locals” (ie wildcat market-makers) is long gone.
Many of the small firms, who saw the writing on wall and had an appetite for the long game, plowed money back into massive technology capex. Most of them just earned the right to say they lost to the best. In some cases they found small, profitable niches where they play the role of suckerfish. Respect to them, even this was not easy.
How about the remaining firms? The private giants the media likes to call “shadowy”. They were the ones who were most adept at assembling teams of software and hardware engineers working with game-theory geniuses to devise algos in a cat-and-mouse battle with competitors. The ones who stayed step-for-step with the exchanges who themselves were experimenting with matching engine rules, data, product listings and connectivity in their own battles for market share.
The truth is progress is cutthroat.
It started with skill and luck. The early big bets on talent and technology meant they were bringing guns to a knife fight. SIG wasn’t know as the “evil empire” on the Amex just because of the black jackets we wore. They understood the risk-reward was completely outsized to what it should be 25 years ago. They were amongst the first to tighten markets to steal market share. They accepted slightly worse risk-reward per trade but for way more absolute dollars. They then used the cash to scale more broadly. This allowed them to “get a look on everything”. Which means you can price and hedge even tighter. Which means you can re-invest at a yet faster rate. Now you are blowing away less coordinated competitors who were quite content to earn their hundreds of percent a year and retire early once the markets got too tight for them to compete.
SIG was playing the long game. The parallels to big tech write themselves. A few firms who bet big on the right markets start printing cash. This kicks off the flywheel:
Provide better product –> increase market share –> harvest proprietary data. Circle back to start.
The lead over your competitors compounds. Competitors die off. They call you a monopoly.
Option market-making is not a monopoly but an oligopoly since a handful of firms control a vast majority of the market share. Oligopolies tend to emerge in industries where high fixed costs are a barrier to entry.
Options market-making derives its high fixed costs from technology capex and the need for extensive market coverage. You can’t price options competitively in a thin margin game if you cannot see and connect to flow. You need both speed and breadth. If you can’t price well and access uninformed orders, then you only get filled when you’re wrong.
All the talent, pipes, compliance, quoting infrastructure, data, and regulatory overhead have to be procured and maintained whether you trade one contract or a million. Whether the VIX averages 9 or 29 for the year.
This is all easily apparent to anyone who's been around the industry. But I’ll add a more editorial thought. Exchanges are the archetype for a business with “network effects”. They are expensive to build and maintain, but the biggest hurdle is the chicken-or-egg problem of attracting liquidity.
Unfolding today, in the wake of Hyperliquid’s great success, there’s a swath of perp exchanges trying to grab a foothold. 10 exchanges aren’t gonna make it…but it’s a lotto payoff for the winner(s). Spoils to the victor of the tournament. Spoils in the form of excess profit. Network effects mean wide moats for incumbents. These are businesses that are closer to monopolies.
I was at the NYSE and the NYMEX before they each “demutualized”. They went from being member-owned organizations that were thought of as utilities to public companies. The incentives shifted from the desires of member firms who had trading permits to public shareholders listening in on quarterly earnings calls.
This is America. What have you done for me lately? Where’s my 15% annual growth? And not only do I want the growth, I want the put. Give me consistency. Well, conveniently for exchanges, some of their biggest customers are those steady oligopolies. You want them to be happy. You want them to be good credits.
At some point, the marginal benefit of allowing an additional market maker’s ability to effect pricing in hopes of growing the pie is not worth destabilizing the symbiotic equilibrium the exchange maintains with its existing market-makers, especially as volumes hum along.
In the past 25 years, we’ve gone from 4 option exchanges to 18. Some of these have been spinoffs from incumbent exchanges. Some have been backed by the market makers themselves. You can make Friedman-esque justifications for these investments such as “customer choice”, but it’s also the standoff at a drug deal. Every investment is another gun drawn, maintaining both the tension and stability of the current equilibrium.
As we zoom in from the industry point of view to the day-to-day business of filling orders, we find the rules of engagement which inherit from the higher-level negotiated equilibrium. A mix of privilege and obligation. This is the environment in which those who become market-makers slot into when they accept their “trader” job.
From this point, we launch deeper into the privileges that accrue to these market-maker seats regardless of who sits in them.
