Imagine Goldman Sachs, the most powerful, most successful, money-making machine in the history of Wall Street.
Now, can you imagine them getting out of the business of lead market-making in ETFs, the most successful, fastest growing trading and investment products ever manufactured by Wall Street?
Me either. But they are.
There’s only one reason, in my opinion, why Goldman would give up valuable turf it paid billions of dollars to own.
Here’s what Goldman does as an ETF LMM (lead market-maker), and why them wanting out is so frightening…
What It Means to Be a Market-Maker
First, I know a lot about market-making. I was a market-maker on the Floor of the Chicago Board of Options Exchange back in the early eighties. I was an OTC market-maker on Wall Street for years. And my hedge funds did the same for our trading strategies into the mid-2000s.
A market-maker’s job is to provide both a “bid” (a price the market-maker will buy stock at) and an “offer” (the price the market-maker will sell stock at) at the same time.
Specialists on the NYSE floor have always been market-makers, broker-dealers have market-making desks, big banks with trading operations have market-making desks, and there are specialty firms that just make markets.
There’s money in market-making. That’s why we all do it.
While it’s technically an obligation to always have to be ready to buy and to sell, and post the prices you’re willing to buy and sell at, it’s also something of an insider’s game… Especially when you’re a big market-maker.
The nuances of market-making are complicated. But in layman’s terms, here’s how it’s an insider’s game and how market-makers make such good money.
Let’s take ETFs for example, since that’s the arena Goldman’s shaking up.
ETFs are essentially stocks. They may be composed of different stocks, commodities, or whatever, but whatever they’re composed of goes into a “trust” that trades just like any stock on an exchange.
The job of market-makers is to provide liquidity. They must be ready to both buy and sell shares, and, by definition, “maintain a fair and orderly market.”
That means that if you or I want to buy or sell shares, and there isn’t another investor willing to take the other side of our trade (for example, not at the price we want, but at some other price), a market-maker posting bids and offers in that stock must fill at least part of our order.
They don’t have to fill all of our order. They have minimum limits (that used to be much bigger), usually as few as 100 to 1000 shares that they must fill, depending on the size they posted they’d be willing to buy or sell at. Like I said, there are a lot of nuances.
Big market-makers like Goldman Sachs have a tremendous advantage when they’re doing their market-making job. That’s because traders send their orders to market-makers who are likely to fill their entire orders most of the time.
The bigger you are, the more capital you have. The more capital you have, the more you trade. The more you trade, the bigger the market-maker you are, and the more likely you are to get “order flow.”
Discount brokerage houses like Schwab and E-Trade don’t trade the orders sent to them; they send them on to market-makers and trading shops to be executed.
Imagine you’re a big market-maker and you get a lot of order flow from discount brokerage houses, from your own firm’s customers, from other traders, as well as institutional players. You might get hundreds or thousands of orders in a minute on some ETFs that are being traded furiously. The advantage you have as a market-maker that sees a lot of order flow in those ETFs is that you know how many shares and at what prices other traders want to buy and sell them at.
With all that “inside information” you can get a good sense on whether there are more buyers or sellers, and whether the stock’s going up or down (at least for a little while). You can trade for your own account based on what you are seeing as part of your market-making, trade-executing duties.
That’s right, market-makers get legal “inside information” and can legally trade on it.
Doesn’t that sound like something Goldman Sachs would be interested in? Of course it is.
Goldman’s been a market-maker for a long time. In September of 2000, Goldman vastly increased its market-making operations by paying a whopping $6.5 billion to acquire renowned market-making and trading powerhouse Spear Leeds & Kellogg LP, which served as lead market-maker for the first U.S.-listed ETF, the SPDR S&P 500 ETF (NYSEArca:SPY), in the early 1990s.
Goldman wanted to be an LMM for as many big ETFs as it could. Now you know why.
Goldman used to be an LMM on the $78 billion iShares MSCI EAFE ETF (NYSEArca:EFA), the $14 billion Guggenheim S&P 500 Equal Weight ETF (NYSEArca:RSP), and the $8 billion WisdomTree Japan Hedged Fairness Fund (NYSEArca:DXJ), based on NYSE information.
But not anymore.
In the past 12 months, Goldman cut its LMM responsibilities down to 178 ETFs from 380, based on NYSE data. And they’re reportedly exiting more LMM positions.
According to a July 24, 2017 Reuters’ article, “Goldman has told fund providers it is scaling back its role as a top lead market maker (LMM) for ETFs and has already slashed the number of funds it supports in that capacity, according to disclosures, fund managers and other trading firms this month.” The article goes on to say, “Relatively high regulatory and other costs of operating as an LMM prompted the pullback by Goldman, one of the few large banks remaining in that role, some people said.”
A spokeswoman for Goldman declined to comment on the bank’s market-making business.
But I’m going to comment, because I have an idea why Goldman’s getting out of the LMM biz.
What Goldman’s Big Move Says About Their Intentions
While regulatory burdens and costs are theoretically an issue for ETF market-makers, no regulation and no amount of expense has ever stopped Goldman Sachs from making money where it sees huge profit potential. In fact, being a market-maker is a huge leg up on everyone.
In a white paper titled Regulating Merchants of Liquidity: Market Making from Crowded Floors to High-Frequency Trading, author Stanislav Dolgopolov explains:
“The nature of externalities in the market for liquidity, embodied by a balance of trading obligations and privileges of market makers, implies a special regulatory status of these market participants. Such obligations and privileges may take a variety of forms with different degrees of formality and transparency. Over years, market makers have enjoyed a number of trading privileges, notably (i) time, place, and information-based advantages; (ii) inherent advantages built into trading venues’ respective architectures, including technology-based and competition-insulating measures; (iii) discounts/subsidies offered by trading venues or issuers themselves; and (iv) order-allocation guarantees.”
But Dolgopolov also points out, “Likewise, trading obligations come in different shapes and sizes, such as (i) specific requirements for quotes/best price presence; (ii) constrains on certain trading activities; and (iii) support of less desirable securities/broader portfolios.”
Given the tremendous advantages of being a “merchant of liquidity” including: “(i) time, place, and information-based advantages; (ii) inherent advantages built into trading venues’ respective architectures, including technology-based and competition-insulating measures; (iii) discounts/subsidies offered by trading venues or issuers themselves; and (iv) order-allocation guarantees,” getting out of that business must have even more compelling advantages.
I believe the real reason Goldman wants to exit its LMM role at ETFs is they want to do away with the “specific requirements for quotes/best price presence” and “constrains on certain trading activities.”
Goldman could make money, a lot of money, trading these securities away from public view.
As an LMM, a lot of eyes are on Goldman. It has responsibilities to the sponsors of the ETFs, responsibilities to regulators, and responsibilities to the public to keep fair and orderly markets in the most popular “retail” tradable products ever manufactured by Wall Street.
When Goldman exits as an LMM, other trading houses (some with a lot less capital and clout) step in. While some people think it’s good to diversify the players on the field, I’m not so sure.
But I’m sure it’s good for Goldman, especially if they’re going to trade these securities for themselves.
As the money flows into ETFs explode into money rapids (which could be for all kinds of reasons, not the least of which being the push towards passive investing strategies), the size of funds and trading volume in them increases. Mostly the bets have been on rising markets and buying as opposed to selling or shorting has been overwhelmingly the trend. The net result of that buying and holding in passive strategies is that the float (outstanding shares available to trade) of ETF shares in the market, as well as the float of all the underlying shares of all the companies shares of stock these ETFs are composed of, are being “parked” in ETF trusts that are being parked in buy and hold strategies.
Think about that. That makes markets less liquid, not more liquid.
Would you want to have to make liquid markets when liquidity all around you, especially in the stocks you make markets in, are less liquid for those mechanical reasons? I wouldn’t.
What I’d want to do is take advantage of tightening liquidity. I’d want to take advantage of suspect mechanics I see developing, including the fact that someone as big and powerful as Goldman is getting out of the LMM business for ETFs and is being replaced by dealers that aren’t as big and well capitalized and savvy as Goldman.
I’d look for opportunities to hit (sell and sell short) less liquid ETFs and their underlying less liquid components to make a lot of money on the downside. I’d figure spreads would widen in a round of panic-selling and as stocks fall they’d widen more because they are less liquid and the market-makers who are supposed to make liquid markets in them step aside because they can’t afford to be the backstopping agents sellers expected them to be and buy falling shares.
In fact, if I saw what Goldman sees, I’d want to get out of making markets in some ETFs so I wouldn’t get blamed for slamming them to make a fortune for myself.
That’s what I’d do if I was big enough to pull something like that off. Because I’m in the business of making money no matter which way the tide turns.
Goldman is in the same business.