Market-making in two-sided on-demand markets

Every on-demand market has “liquidity providers” and “liquidity takers”. In fact, the market is “on demand” only for the liquidity takers, for when they arrive at the market there are liquidity providers who are providing this liquidity. In other words, the liquidity takers’ demand is instantaneously supplied by the liquidity providers, who make sure that the market is on demand.

Now, providing liquidity is risky business. Let us look at it from the perspective of stock markets, where the concept of market making is most well established. Market makers in a stock market are responsible for keeping “live quotes” (on both the buy and sell side) at all points in time, so that whenever a trader enters the market, there is ready liquidity available for the trader to execute his trade “on demand”.

Let’s say I’m a market maker and have put out a bid (offer to buy) on a particular stock. Now, if there is a massive downward price movement in the market, my bid gets “taken out” (i.e. a counterparty takes me up on my offer to buy and sells me the stock at the price I’ve quoted), and the market continues hurtling down. Notice now that the moment my bid got “taken out”, I have a long position in the market (since I have now purchased the stock), and the continued downward movement of the market leads to a loss. It is similar if I’m making a market on the ask side and there’s a massive upward price movement.

To put it another way, the market makers (i.e. liquidity providers) are effectively “short optionality”, as they constantly need to write the option of trading at a particular price at any given instant. The “liquidity taking” side is effectively “long optionality”, since they have the option to trade at that particular instant at the price quoted by the market maker.

The question is how I as a “liquidity provider” (as a market maker I’m providing liquidity) need to be compensated for the liquidity I’m thus providing. In the American stock exchanges, for example, market makers are charged a much lower exchange fees than the liquidity takers (the opposite side which trades with the liquidity provided by the market maker). Sometimes the exchange even provides a fee to the market maker in exchange for “always being there” in the market. This is a recognition of the costs being borne by the market maker in order to provide liquidity. The question is how this can be replicated in other “on demand” markets.

It is well known that taxi providers such as Ola and Uber provide attractive “non-linear” (not directly tied to rides) incentives to drivers for being “switched on”. The economic rationale behind that is to compensate these drivers for the cost and risk associated with being “switched on” (there is opportunity cost in being switched on in terms of the driver’s time, risk of getting an unattractive ride, etc.). These incentives, are in other words, compensation to the drivers for “providing liquidity” to the market. In the long run, this gets paid out of the fees charged from the liquidity takers.

Similarly, in the electricity market (though we seldom look at it that way, electricity is the classic “on demand” market, since electricity cannot be stored and needs to be generated in response to demand), grids typically pay power producers a fixed cost to just “be there”. This is again in addition to the per unit cost of power that the producers are paid when power is actually drawn from them (this is the classic “two part tariff” that is prevalent in the electricity sector). On similar lines, think of a lower power tariff to customers who are willing to accept frequent power cuts!

In “traditional, one-sided” markets, where the seller of the good/service is also the owner of the “market” where the sale takes place, the seller usually absorbs this cost of providing liquidity. For example, your neighbourhood grocer (note that this is again “on demand” since the grocer sells you groceries whenever you demand it) provides liquidity by way of keeping his shop open (even when there are no customers) and maintaining inventory. A car mechanic provides “on demand” service by (again) keeping his shop open and having spare mechanics who can service spot demand immediately.

In a platform business (or “two sided market”, or a market where the owner of the marketplace is not a participant), however, the owner of the market cannot provide liquidity himself since he is not a participant. Thus, in order to maintain it “on demand”, he should be able to incentivise a set of participants who are willing to provide liquidity in the market. And in return for such liquidity provided, these providers need to be paid a fee in exchange for the liquidity thus provided.

Thus, the key to the success of an “on demand” marketplace is to be able to incentivise enough market participants who are willing to provide liquidity – who are willing to forego instantaneous matching, and take risk of not being matched so that other market participants can enjoy the liquidity thus provided. This process also involves the clever structuring of incentives such that such compensation to the liquidity provider is paid for by the liquidity taker – this is nontrivial since this may not be consistent with the way in which the marketplace actually charges participants!

Cross posted from LinkedIN

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