What is a Market Maker?

Introduction

The term market maker refers to a corporation or individual who actively quotes two-sided markets in a particular security by giving bids and offers (known as requests) together with the market size of each. The bid-ask spread is the profit made by market makers who provide liquidity and depth to markets. Principal trades, in which they transact on behalf of their own accounts, are also possible.

 

What is Market Makers?

Large financial firms and banks are the traditional market makers. They play a role in maintaining market liquidity, or the amount of trades necessary for transactions to go off without a hitch. Without market makers, liquidity in the market would certainly dry up. That is to say, if there aren’t enough buyers in the market, investors who wish to sell assets will be unable to do so. Bonds can be sold to market makers since they are essential to the market’s smooth operation.

If an investor is willing to pay a certain amount, a market maker will buy or sell from them. Market makers fulfil the market’s need for securities by purchasing and selling at prices that are reflective of supply and demand. A security’s price falls when demand is weak and supply is plentiful. A security’s price will rise if demand is high and there is a scarcity of supply. For the most part, market makers must purchase and sell at the prices and quantities they quote.

For the sake of market liquidity, many brokerage companies offer their clients market making services. An individual trader, sometimes known as a “local,” might function as a market maker. Due to the enormous securities required to support the amount of purchases and sales, the great majority of market makers work on behalf of large institutions.

Each market maker provides buy and sell prices for a certain minimum number of shares. As soon as the market maker receives a purchase order from a customer, they liquidate the corresponding number of shares from their own stock. This permits them to fulfil the order.

A market maker’s primary duty is to consistently quote the prices at which it will purchase and sell securities. Market makers are required to provide not just the best bid and best offer prices, but also the volume at which they are willing to deal. Market makers are obligated to maintain these standards in all market conditions. Market makers must maintain self-control in times of market volatility to keep enabling trades as usual.

 

How do Market Makers earn Profits?

Market makers generate income from the gaps (or spreads) between the prices they offer investors and the prevailing market prices. Providing liquidity to their client companies is another way market makers earn commissions.

Market makers operate on both the buy and sell sides of the market, charging a premium for doing so. The bid and ask, or buy and sell, prices are set by market makers through the use of quotes. Those looking to offload a security would receive the bid price, which is lower than the going rate. The ask price is slightly higher than the market price and is what an investor would pay to purchase securities.

Two major stakeholders in the forex industry are brokers and market makers. Brokers are businesses that connect buyers and sellers of assets. Market makers are rewarded for the risk of retaining assets since they may observe a decrease in the value of a security after it has been purchased from a seller and before it’s sold to a buyer.

As a result, the aforementioned spread is often applied to all securities they research. An online broker may display a bid price of $100 and an ask price of $100.5 when a client searches for a stock. This means the broker makes a profit of $0.05 on each share sold, or $100. A tiny spread can result in a significant daily profit if trade volumes are high enough.

A country’s securities regulator, such the Securities and Exchange Commission (SEC), must approve the bylaws of an exchange before it can begin accepting market makers. Market makers’ legal protections and obligations varies depending on both the exchange where they operate and the stocks or options they trade.

 

Market Makers (MM) vs. Designated Market Makers (DMMs)

Market makers are used by many exchanges, and they compete with one another to set the best bid and offer prices in order to get customer orders. But some companies, such as the New York Stock Exchange (NYSE), have what’s termed a designated market maker (DMM) system instead.

DMMs, which were formerly known as specialist systems, are solitary market makers that control the majority of the order volume for a specific security or set of securities. The New York Stock Exchange (NYSE) operates as an auction market, thus investors submit bids and asks in a competitive fashion.

The specialist then makes sure that these bids and requests are reported accurately and in a timely manner to the entire market. All marketable trades are completed, the best price is kept, and the floor is kept in order under their watchful eye. The specialist is also responsible for determining the stock’s opening price each day, which, depending on after-market developments, may be different from the previous day’s closing price. According to supply and demand, the expert establishes the fair market price.

 

Impact of Market Makers on the Stock Market

Stock markets would collapse without the services of market makers. In volatile markets, market makers are the only ones who would actively buy and sell shares. For instance, if a company fails to meet profits expectations, investors will likely sell their shares. In order to prevent complete anarchy, the market needs buyers to step in amid sharp declines.

Market makers not only act as a buyer or seller of last resort, but also contribute to a narrow spread between the asking and bidding prices. Slippage for retail traders is minimised on widely traded, highly liquid stocks due to the narrow gap of just a cent or two between the bid and ask.

That’s in stark contrast to less popular assets, where there are much fewer market makers. Bid/ask spreads can be several percentage points wide in low-capitalized, low-volume enterprises with limited market-making ability, resulting in high transaction costs for retail traders.

Market makers are crucial to the smooth functioning of electronic trading in financial products, and their significance cannot be overstated. In providing liquidity, market makers serve as a key component of the market’s overall structure. The actions of market makers have a direct and crucial effect on the market and its players. Some of the results of market makers at work are as follows:

Maintaining Price Stability

Because of market makers, the value of financial assets may be kept relatively stable, with no sudden spikes or drops. There are grey areas where buyers’ and sellers’ emotions aren’t entirely clear cut. In the first scenario, purchasers typically look to get the best deal possible, while vendors look to get the highest possible price. There may be no buy or sell offers on the market if scenario 2 occurs. With a market maker present, any trader can instantly locate a willing vendor or buyer at a price that is consistent with recent transactions. Market makers use this method to keep prices stable.

Maintaining Supply and Demand (Liquidity)

Market makers ensure that all market participants can purchase or sell any financial asset in the appropriate quantity at prevailing market pricing. In some situations, it can be difficult to pin down buyers’ or sellers’ motivations with any precision. In the first scenario, supply and demand are ill-defined, resulting in a low number of buy and sell bids and a wide range of prices. It’s possible that there are no buyers or sellers in the market when sentiment is clear and unambiguous, as in the second scenario. Any trader can always find a willing buyer or seller thanks to the market maker’s role in keeping the market liquid.

Maintaining Trading Volume

Markets are more liquid and stable and, as a result, the possibility of a halt in market activity owing to a lack of availability of a particular financial instrument is reduced. Because of this, business volume is boosted as well. Large quantities of equities, cryptocurrencies, or foreign exchange can be bought and sold at market price when trade volumes are high enough. Traders and investors are then drawn to an exchange or broker, as they tend to base their decisions on the volume of transactions taking place there.

Market makers may be given additional authority by the exchange or broker to ensure a steady stream of trades. For instance, the market maker can view the pending orders, take profit and stop losses, but not the most recent deals or the “stack” of limited orders (the list of price general market orders of all traders).

Recognition of Quotations

Official acknowledgment of closing, opening, buy and sell prices, etc., is crucial for various market participants including investment funds and commercial banks. Specialists are required by the exchange to set these pricing for individual instruments.

Mediation between Buyers and Sellers

For a market maker to fulfil their role effectively, all deals at the exchange must involve professionals who evaluate the quality of their work and set the terms of the transaction. This feature can be helpful in situations where it is crucial to guarantee that the transaction will be finalised at the agreed upon market price and carried out in its entirety.

Information Provision to Trading Participants

As part of their role as market makers, specialists record all active and closed trades in the specialist’s book and make this data available to potential buyers.

Pros and Cons of a Market Maker

PROS

Provides liquidity and depth

Can buy or sell in large numbers

CONS

Not transparent

They may trade against you

Conclusion

The role of market makers in maintaining the efficiency and smooth functioning of the financial markets is crucial. They accomplish this by always being in a position to acquire or sell assets. They operate in a highly competitive market and are subject to strict regulations. In a perfect world, the sum of these parts would provide investors with a well-functioning market where prices are competitive.