ETOs & DMMs

October 14, 2006

One of the differences between order driven and quote driven markets is that all liquidity is supplied by dealers on quote driven markets. When you trade on a quote driven market like Bloomberg, you must trade with a dealer. By contrast, on an order driven market like Liffe or Eurex, any participant can trade with any other. All that is necessary is that orders from opposite sides of the market match.

This article discusses the role of designated market makers in order driven markets for stocks, futures and options.  The DMMs role is to stop the screen going dark, to be the liquidity provider of last resort when no one else is trading. This is especially important for ETOs – exchange traded options. Unlike a futures market, there isn’t natural interest on both sides. Sellers protect themselves from future price drops, and buyers from rises in the underlying. The analogous hedges with options are to buy puts to hedge against price drops in the underlying, and to buy calls to hedge against rises. Selling puts and calls isn’t a natural hedge on the underlying. But an options exchange needs sellers, hence the importance of designated market makers.

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