Market Maker

A person or financial organization that provides liquidity, facilitating the buying and selling of financial instruments within financial markets.

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:January 7, 2024

What is a Market Maker?

A market maker is a person or financial organization that provides liquidity, facilitating the buying and selling of financial instruments within financial markets

A market maker quotes the buy and sell prices for a financial instrument, serving as a middleman between buyers and sellers.

The maker agrees to purchase or sell the asset at the indicated rates to create a market for the asset. Providing liquidity to the market is a market maker's primary responsibility to maintain a steady and organized flow of trade in particular securities.

Market makers facilitate the orderly trading of stocks, options, and other products listed on financial exchange systems.

Nowadays, most exchanges run digitally and let different people and organizations open positions in a certain asset. Due to the several liquidity providers placing bids and asks on a particular security, this encourages competition. 

This generates substantial market depth and liquidity, which is advantageous to institutions and retail traders.

Key Takeaways

  • A market maker is an individual participant or member firm of an exchange that purchases and sells shares for their account.
  • Market makers participate in various financial markets, such as derivatives, equities, bonds, and currencies. Their presence is essential across various asset classes to improve market liquidity.
  • Market makers benefit from the variation in the bid-ask spread while giving the market depth and liquidity.
  • The most prevalent liquidity providers are brokerage companies offering investors buying and selling plans.
  • Because a security's value can decrease between the time it is purchased and when it is sold to a different buyer, market makers are paid for the risk of retaining assets.

Understanding Market Makers

Traditionally, market makers are banks or brokerage firms extending trading services. These banks and brokerages facilitate substantially higher trading activity and service use by creating a market for securities.

Market makers often keep an inventory of all the securities they trade. They also continuously quote the prices they're willing to pay (a bid price) for additional shares and the price they're willing to accept for the sale of their shares (an ask price). 

The bid-ask spread is the amount that separates the buy and sale quotes.

Upon receiving a buy order, a liquidity provider will promptly sell shares from its stock at the price offered to satisfy the order. In the event that it gets a sell order, it purchases shares at the indicated price and places them in stock.

Even if the opposite side isn't immediately available to finish the transaction, it will accept either side of a trade.

Liquidity providers will buy and sell the same underlying security numerous times during the day. If successful, a liquidity provider's operations will result in a profit by selling shares at an average price slightly greater than what was paid for them.

Hedge funds and other non-bank organizations like stock exchanges are taking on a more market-making role as banks pull back from certain conventional tasks, which will improve market efficiency and liquidity.

How do Market Makers Profit?

Market makers are paid to assume the risk of retaining assets since they might see a decrease in a security's value after buying it from a seller but before selling it to a buyer.

Here’s how they profit:

  1. Bid-Ask Spread: They provide a financial instrument's ask and bid prices. The asking price is the lowest amount a seller is ready to take, while the bid price is the highest sum a buyer is willing to pay. The bid-ask spread is the difference between these two prices.
  2. Providing Liquidity: Liquidity providers give the market liquidity by pledging to purchase or sell the financial products they cover at the given prices. They are prepared to make trades and facilitate exchanges between buyers and sellers.
  3. Volume of Trades: Market makers capitalize on small price differences by engaging in a high volume of transactions. Although individual spreads may appear negligible, the cumulative profit from a large number of deals can be substantial.
  4. Risk Management: Market makers control the risk they take on proactively. They modify their trading techniques and bid-ask spreads in response to changes in the market, order flow, and possible hazards. By managing risks well, they may reduce losses and increase earnings.

Advantages of Market Maker

Market makers are essential to the functioning of financial markets and provide several benefits to both market players and the financial system at large.

Here are some advantages:

  1. Investor Confidence: The presence of market makers instills confidence in investors, signaling that the securities in question are valuable investments. They can analyze securities from a perspective that smaller investors cannot, and their actions serve as a gauge for the securities available in the market.
  2. Security Availability: Because depositors function as custodians and assist investors in obtaining the necessary exposures, they make available securities unavailable to investors, making investing in such securities easier and safer.
  3. Liquidity Provision: Market makers assist in reducing the bid-ask spread, which facilitates easier and more economical buying and selling of securities by investors.
  4. Risk Management: Market makers employ techniques like delta hedging to mitigate the risks involved in maintaining inventories, which helps them maintain their financial stability. They also efficiently manage their inventory of securities, absorbing transient mismatches in supply and demand.
  5. Market Efficiency: Liquidity providers improve the market's overall efficiency by instantly connecting buyers and sellers, facilitating speedier trade execution. By synchronizing prices across many marketplaces, they enhance market efficiency by spotting and seizing arbitrage opportunities.
  6. Profit Incentives: Market makers' profit motives drive their sustained participation, thereby supporting the financial system's stability. Participants in the market can gain from improved prices and service quality as a result of healthy competition among other movers.

Disadvantages of Market Makers

Liquidity providers enhance the efficiency of financial markets and supply necessary liquidity, but their position may also come with certain drawbacks and difficulties.

Here are some disadvantages:

1. Conflict of Interest

Market makers frequently work as brokers and dealers, which creates a conflict of interest because brokers are expected to find the best execution for their clients. 

In contrast, dealers act as counterparties and trade for profit. Creating such a rift within the company is challenging, so investors need to exercise caution.

2. Impact Market Integrity 

Liquidity providers have the ability to affect market prices since they trade in a large quantity of securities. Their acts could, therefore, affect the stock markets' integrity. 

These actions might encourage investors to behave in a herd, making such behaviors unsuitable for the market's well-being and investment.

3. Insider Trading 

Because liquidity providers have access to a great deal of information not available to the general public, there is always a chance that some people will engage in insider trading and profit unfairly.

Note

Insider trading could result in harsh regulatory measures and the unintentional harming of innocent investors.

4. Bid-Ask Spread Cost

The bid-ask spread is a cost to traders that makers reap. Investors may find this detrimental, particularly in markets with larger spreads.

5. Risk Exposure

Securities are kept in stock by market makers, and shifts in the market might result in inventory losses.  A market maker's financial difficulties may exacerbate more general systemic vulnerabilities, particularly if the maker is a significant participant in the market.

Example of a Market Maker Scenario

Consider the trading scenario of a market movement in Apple Inc. stock on the day of a company product announcement. One morning, there might be a lot of excitement about new Apple products. Before the event, traders are clamoring to purchase Apple stock.

The mover sets their bid and asks range higher than the previous market close because they believe there will be more demand than supply for Apple shares, and they anticipate trading in both directions at this price point.

As the market opens and Apple shares continue to rise, the market makers may find themselves compelled to sell a significant portion of their inventory to retail investors at steadily increasing prices.

Although few other traders like to sell before the product launch, this is a helpful market function. Nevertheless, a market maker has an obligation to give a bid and ask regardless of the state of the market.

When the afternoon finally comes, we can all agree that Apple's presentation was a letdown. Apple's staple items lack any novel features, and traders get disinterested in the narrative. There is currently a rush to sell Apple stock, as there aren't enough buyers.

That is, excluding the liquidity providers. When traders shift to liquidate their holdings, the market maker is a consistent purchaser of Apple shares at falling prices. The liquidity provider replenishes their stock of Apple shares, previously sold in the morning, in this manner.

In this hypothetical scenario, the market leader Apple may have made money that day or lost money. Liquidity providers are vulnerable to risk at all times. However, market-making endeavors are intended to be profitable in the long run; otherwise, some may give up on the field.

Conclusion

Liquidity providers are essential to the operation of financial markets because they facilitate trades, provide liquidity, and improve market efficiency.

A wider variety of market participants can trade in a more liquid and accessible environment thanks to their constant capacity to quote, bid, and ask prices, manage inventory, and react to order movement.

Liquidity providers have a number of benefits, such as lower bid-ask spreads, effective price discovery, and greater market accessibility, but they also have disadvantages and other unforeseen difficulties.

Risks of information asymmetry, bid-ask spread expenses, and conflicts of interest are only a few of the issues that call for strict regulation and close supervision.

Risk-taking pays off since they can sell the shares they repurchase at a higher price. Their actions ensure that there will always be a willing seller or buyer of stocks at a reasonable price, which is crucial to the operation of markets.

Researched and authored by Ray Bassil | LinkedIn

Reviewed and edited by Parul GuptaLinkedIn

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