Imagine Goldman Sachs Group Inc. (NYSE: GS), the most powerful, most successful moneymaking machine in the history of Wall Street.
Now, can you imagine it 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 it is.
There's only one reason, in my opinion, why Goldman would give up valuable turf it paid billions of dollars to own.
And it's frightening.
Here's what Goldman does as an ETF LMM (lead market-maker), and why GS 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 Options Exchange back in the early '80s. I was an over-the-counter 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 1,000 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 of 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 (NYSE Arca: 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 (NYSE Arca: EFA), the $14 billion Guggenheim S&P 500 Equal Weight ETF (NYSE Arca: RSP), and the $8 billion WisdomTree Japan Hedged Fairness Fund (NYSE Arca: 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 it's 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.
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.