Foundations · F3 · 8 min
Market making, inventory and the balance sheet
Adjust a price to sell off unwanted stock, split a dealer’s profit into its two parts, and work out the capital a position uses.
In the news: When a story says dealers “stepped back” in a sell-off, it means their balance sheets were full.
The essentials
- Inventory and the axe
- Inventory is what a dealer has bought from clients and not yet sold, or sold and not yet bought back. The side it wants to trade out of is its : long bonds, it is axed to sell and prices that side keenly.
- Skewing the quote
- Moving bid and offer the same way to work off inventory: down when long, to attract buyers; up when short. At 0.01 per £1m held, being long £3m moves a 100.00 middle price to 99.97.
- Two parts of a dealer’s profit
- The spread captured on each trade, small and fairly certain, and the gain or loss on inventory while it is held, usually larger. Buying £20m 0.05 below mid captures £10,000; a 0.20 fall then loses £40,000.
- Capital and risk weights
- Capital is the bank’s own money and takes losses first. Riskier assets carry higher risk weights and need more: £100m at a 50% weight, with capital set at 10% of , uses £5m.
- Market making and proprietary trading
- Market making serves clients and earns the spread; bets the bank’s own money on a view. The US bans most of it at deposit-taking banks.
Skewed quote and capital used
new mid = mid − skew × inventory; capital = size × risk weight × capital rule
- skew
- how far the middle price moves for each unit held
- inventory
- what you hold: positive if long, negative if short
- capital rule
- the share of risk-weighted assets held as capital, such as 10%
How it works
1. Too many umbrellas
A market stall that bought too many umbrellas cuts its price to sell them faster, and stops buying more until the pile shrinks. Dealers do the same with bonds. Bonds a dealer has bought from clients and not yet sold are its inventory.
2. The axe
A position a dealer wants to get rid of is its . A dealer holding too many bonds is “axed to sell”; one that has sold bonds it doesn’t own is “axed to buy”. Dealers tell clients their axes, because those are the trades they will price most keenly.
3. Skewing the quote
To work off inventory, a dealer moves both its bid and its offer the same way: it skews its quote. Long bonds, it shades both prices down, so its offer attracts buyers and its bid puts off sellers. Short bonds, it shades both up.
4. Skewing with numbers
Say is 100.00 and you quote 0.02 either side: 99.98–100.02. You move your middle price 0.01 for each £1m you hold. Long £3m, the middle drops to 99.97, so you quote 99.95–99.99.
5. Two parts of a dealer’s profit
Each client trade brings a small, fairly certain gain: you buy at your bid, below the middle price. That is the spread captured. Then the price moves while you hold the bonds: that gain or loss on inventory is usually bigger. Buy £20m 0.05 below the middle and you capture £10,000; if the middle then falls 0.20, inventory loses £40,000.
6. Capital: the bank’s own money
A bank pays for what it holds mostly with deposits and borrowing, and partly with its own money, its capital. Losses come out of capital first, before depositors lose anything, so regulators set a minimum. Every bond a dealer holds uses up some of it.
7. Riskier assets need more capital
Each asset gets a risk weight: 100% for a typical company loan, much less for safer assets. If the rule is capital of 10% of , then £100m at a 50% weight needs £100m × 50% × 10% = £5m of capital.
8. Profit per pound of capital
Capital is scarce, so a desk asks what a position earns on the capital it uses, not on its size. A 1% margin at a 100% weight earns 1% ÷ (100% × 10%) = 10% on capital. A 0.8% margin at a 35% weight earns 0.8% ÷ 3.5% ≈ 23%: a thin margin on a safe asset can win.
9. Serving clients or betting
Trading to serve clients is market making. Betting the bank’s own money on where prices go is . US rules, the , ban most of it at banks that take deposits, and UK rules make the largest banks keep everyday banking separate from trading.
Worked example
You make prices in a company bond with a fair middle price of 100.00, quoting 0.05 either side. A client sells you £20m at your bid of 99.95. Before another buyer appears, the middle falls to 99.80. The bond’s risk weight is 100% and the capital rule is 10%.
- Spread captured: £20m × 0.05 ÷ 100 = £10,000.
- Inventory: £20m × (99.80 − 100.00) ÷ 100 = −£40,000.
- Total: £10,000 − £40,000 = −£30,000.
- To sell, skew down: quote, say, 99.72–99.82 rather than 99.75–99.85.
- While you hold the bonds, they use £20m × 100% × 10% = £2m of capital.
−£30,000: the inventory loss swamped the spread, and the bonds tied up £2m of capital while held.
Check yourself
9 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
You’re long a bond a client wants to buy. How do you price it?
What’s the difference between market making and proprietary trading?
Remember
Capital = exposure × risk weight × ratio
A dealer earns a small spread but carries a larger inventory risk, and every position it holds uses scarce capital.
Sources
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.