Last week, the German financial regulator BaFin, felt compelled to publish a notice on investor protection with regard to Market Making with a focus on derivatives and structured products. The increasing number of complaints the financial watchdog had received from investors in particular in respect of leveraged products such as Contracts for difference (CFDs), Forex trades or Options, and investment certificates. This group of investment products has come under pressure for a while now and has culminated in product interventions by regulators globally. For instance, the European Securities and Markets Authority (ESMA) last year issued restrictions on the marketing, distribution or sale of CFDs to retail investors and an outright prohibition of such activities for Binary Options, which were subsequently extended.
Now BaFin reports that many investors had complained about the price assigned to certain products by market makers or the temporary halt in trading in these, calling for investigations into fraudulent behaviour. BaFin highlights though that in most cases no fraud has taken place. Instead, it is simply the nature of market making that causes these events.
What is Market Making?
To understand these sometimes strange trading developments, it is necessary what exactly market making is.
Basically, a market maker is a financial institution that quotes a buy and sell price in a financial instrument. The market commits to hold these financial instruments in inventory and thus provides liquidity in said product. Obviously, the market maker doesn’t do that for sheer pleasure or the good of the financial system. Instead, they hope to make a profit on the bid-offer spread.
It can be quite profitable but comes with not insignificant risks as so many things in trading financial instruments and periodically come under fire for their market practices. High-Frequency Traders have been accused of not providing real liquidity as they were simply listing quotes that could not be traded with as they suddenly vanish, a practice coined ghost liquidity.
However, market makers in the traditional sense are an important element of functioning markets and exchanges often incentivise the activity to make sure that they provide relevant prices and liquidity. After all, an exchange that cannot provide neither is not going to be very attractive for investors. To make sure that market makers play by the rules though exchanges issue a number of obligations they have to adhere to that can either stem from regulation or the rules of the exchange itself. For example, Borsa Italiana, the Italian stock exchange, lists a number of obligations that directly derive from MiFID II such as:
– Obligation to display bid and ask prices continuously, i.e. the market maker shall comply with the obligation to enter simultaneous buy and sell orders for comparable quantities;
– Obligation to display a minimum size, i.e. the market maker must comply with the obligation to display a minimum size of €5,000 for all instruments in which they support as a market makers, while during stressed market conditions the size is reduced by half;
– Maximum spread obligation: The market maker must comply with the same maximum spread obligation that is set for the Specialist for the instrument(s) they support as a market maker;
– Comparability obligation, i.e. the market maker must make sure that the total bid size orders does not diverge more than 50% against the total ask size orders.
The exchange also requires market makers to adhere to their obligations for 50% of each trading day and the assessment will be calculated and disseminated on a monthly basis.
Specifics of Market Making in Structured Products
This is obviously only a small part of the legal framework a market maker operates in. IT requirements and other aspects are set out in the respective agreement, which depends on the relevant exchange and the instruments covered by the market maker. What is so specific though about leveraged products and investment certificates that so many investors have complained about their treatment and that BaFin felt the need to clarify certain aspects?
Risky Business
To start with, the instruments in question are high-risk. Investment certificates and leverage products are securities whose price depends on a benchmark, the underlying. Typical underlyings are indices, stocks, bonds, foreign exchange or commodity futures. Investors therefore do not invest directly in an underlying, but in a financial instrument whose performance is based on that of the underlying. As a result, they gain no rights to the underlying. Private investors can invest in markets that would otherwise be difficult to access. Some of these products have an indefinite life, but can be terminated or sold on specified dates. In addition, investors have the opportunity to purchase such products not only during the subscription period but also after the issue in secondary market trading.
According to the regulator, the price development complaints are mainly about leverage products such as factor certificates, warrants and turbo warrants or knock-out certificates. These derivatives track the price performance of an underlying leveraged. The investor thus has the opportunity to participate disproportionately in the price movements of the underlying. Leverage products are considered high-risk because there is a risk of total loss for the investor.
Issuer = Market Maker = Issuer Market Making
The second factor is that for investment certificates and leverage products, the issuer generally also acts as market maker. When buying or selling such investment certificates and leverage products, investors either trade directly with the issuer, i.e. over the counter (“OTC”) or with a market maker at a trading venue. In both cases, the price is not determined as a derivative of supply and demand.
Price Building
In general, in securities trading, a distinction must be made between the price determination via the order book and the price determination by a market maker. The prices of stocks or bonds are typically derived from supply and demand. The price of a security compensates for supply and demand. The price is determined by the order book in which buy and sell orders are collected. The price of a security is the price at which the highest possible revenue is generated or at which most market participants are prepared to buy or sell the security. Thus, the price is determined directly by supply and demand for the security. The individual stock market orders are executed against each other. The market participants meet directly and the liquidity of the security results from the number of buy and sell orders.
The Need for Market Makers
Couldn’t prices than be determined automatically, e.g. through a system that factors in all these elements to provide this function? Not if we are to adhere to the rule of supply and demand, because the price of a security can only be based on supply and demand if there is sufficient liquidity or market breadth. If there is not a sufficient number of buy and sell orders, which is generally the case for investment certificates and leverage products, there can be no reliable price for supply and demand. In such cases, use is made of market makers, which increase liquidity in the market or in relation to a specific financial instrument and thus ensure trading. If pricing on supply and demand is not reliably possible, the market maker can also place a price on the secondary market for less liquid securities such as investment certificates and leverage products.
BaFin makes an excellent example in its clarification: the Frankfurt Stock Exchange trades around 11,200 shares and around 1,700,000 certificates in the over-the-counter market. Not all of these certificates have sufficient liquidity to ensure lasting tradability. For this reason, the issuers usually act as market makers for the products concerned and set prices. This allows investors to sell a certificate during the term via a trading venue or to acquire one after the subscription period. In addition, the price can also serve as a value indicator for investors.
The problem for the investor is though that, at least in principle, the issuers of certificates and warrants do not commit themselves to a continuous indicative, that is non-binding provision of buying and selling prices. This is also stressed in the base prospectuses, so that even in ordinary market conditions, there is no legal obligation to set prices. In addition, issuers might not guarantee continued market making throughout the life cycle of the instrument, even if it is in their interest to ensure that as many securities as possible get traded since the issuer only make money when trading takes place.
Different exchanges try to counter these issues in different way through their general terms though it is naturally very difficult for investors to understand these aspects and make a conscious decision based on such elements.
Instead investors expect a direct correlation between the underlying asset and the warrant or certificate. For this reason, they assume that, for example, an increase in the price of the underlying in a call warrant automatically results in a price increase of the derivative in the same amount. However, this disregards the factors described above as well as others such as the inclusion of the cost of a structured product for hedging, margin, the costs of structuring and selling the securities. For these reasons, the price calculated by the issuer may well differ from the financial value of the security.
The Bottom Line
So, market making in leveraged products and investment certificates comes with a number of differences than that of plain vanilla products such as stocks. But what is the lesson for the investor?
To begin with, the German regulator stresses that investors should be aware that the prices of these instruments are generally not specified through the order book, so they are not based on supply and demand. These financial instruments may be traded either off-exchange with the issuer or through a trading venue with a market maker. In both cases, the issuers themselves set the price of the financial instrument at their own discretion. Margins or costs for the sale or costs of risk hedging can also be priced into this price. The issuers are also not obliged to quote on a continuous basis. They can suspend or terminate price determination, for example in the case of extraordinary market events and high volatility.
Furthermore, investors should keep in mind that the price of these securities does not depend solely on the performance of the underlying asset even though these instruments are in theory based on the development of the underlying. Due to the inherent product structure, however, prices may deviate. In addition to the performance of the underlying, other factors may influence the price. Investors should therefore know that the price of the security could differ materially from its financial value.
And lastly, investors ought to be well aware of the risks of investing in such products as outlined in the warnings about risk as set out in the base prospectuses. Investors must therefore answer a fundamental question before they start trading in such products: Do I really understand the functioning of the instruments and, more importantly, am I prepared to bear the risks?