Making markets means carrying inventory risk

Graduate · enrolled learners

This lesson opens with Ronin Capital, March 2020.

What happened

Ronin Capital was a proprietary trading firm and market maker that stood ready to buy and sell across many markets, holding inventory as it did so, and in the extreme volatility of mid-March 2020 it took losses large enough that it could not meet the margin its clearinghouse required. The CME declared Ronin in default and moved its positions to other firms to be liquidated, and Ronin wound down. Making markets means holding inventory in order to earn the spread between the buy and sell price, which is comfortable in calm times but means being long or short exactly when prices gap violently, so the inventory that earns a spread in normal conditions becomes a large, mark-to-market loss in a crisis. Nothing was stolen and no single trade was the villain; the firm simply held positions whose losses, in a historic dislocation, exceeded the capital it could post against them. Ronin had provided liquidity for years, and the same activity that earned the spread was the activity that sank it when the market moved far and fast.

The decision point

A market maker earns its living by quoting a price to buy and a price to sell and capturing the spread between them, but doing so means continuously holding inventory, positions it did not choose for a view but accumulated by making markets, and that inventory carries real risk that is largest exactly when the market moves violently. Ronin Capital is the case: a market maker whose March 2020 inventory losses exceeded the margin it could post was declared in default and wound down, undone not by a bad bet but by the ordinary business of holding inventory in an extraordinary dislocation. This is the first thing to understand about market making: the spread is not free money for standing in the middle; it is payment for taking on inventory and the risk of holding it, and that risk concentrates in the crises that also widen the spread and make the activity look most lucrative. So a market maker's survival does not rest on the spread it earns but on the capital and risk limits that let it hold and fund its inventory through a dislocation, because a firm that cannot post the margin on its inventory when prices gap is insolvent regardless of how profitable its market making looked the week before. The discipline, for anyone providing liquidity or relying on those who do, is to see market making as a risk business first and a spread business second, to size inventory to the capital available in a crisis rather than the profit available in calm, and to remember that Ronin provided liquidity for years and still did not survive the day its inventory losses outran its capital.

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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