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, once the largest proprietary trading name in Chicago's futures markets and a direct clearing member of CME Clearing, holding a large book of positions, and in the extreme volatility of mid-March 2020 it took losses that left it, in the CME's words, unable to meet its capital requirements going forward. On March 20 CME Clearing auctioned off Ronin's portfolios to other firms, and the same day FICC, the clearinghouse for US Treasury trades, ceased to act for Ronin under its rules. Ronin had no customer business, so no customers were affected and the CME guaranty fund was untouched, and by August 2020 the firm was withdrawing the licenses it needed to trade. 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 the CME alleged no wrongdoing; the firm simply held positions whose losses, in a historic dislocation, left it short of the capital a clearing member must keep. Ronin had traded through calm markets for years, and the same kind of book that earns in calm markets was the book 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 trading firm whose March 2020 losses left it unable to meet its capital requirements had its portfolios auctioned off by CME Clearing and wound down, undone not by any alleged wrongdoing but by the losses on a book of 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 whose inventory losses consume its capital when prices gap is finished 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 traded for years and still did not survive the week its 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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