I had the chance to work on a buy side desk over the summer, but never really understood the difference between a market maker at an Investment Bank and a specialist. Also, how well does the market maker (by this i mean trader) need to know about the sector he is trading in? Does he need to have knowledge comparable to an analyst? Or is his knowledge more "inch deep mile wide"? Thank you.
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This isn't a newb question. It's got a lot of intricacies to it- and it's stuff only a floor broker or trader with a lot of experience in executions is really qualified to explain. I'm just the friendly desk developer, but I'll take a stab at it:
A specialist IS a market-maker. But a market-maker isn't a specialist.
I think the specialist system is really specific to the NYSE. The specialist is basically a guy that acts as both a market-maker and a referee to help line up trades. That's not the market maker's responsibility- he's only committing to provide a certain degree of liquidity and even then, to a lesser degree of responsibility than the specialist.
An exchange can have multiple market-makers, but I believe there is only one specialist. And again, I think the specialist system is generally pretty specific to the NYSE. The specialist makes greater commitments to providing liquidity, and in return, gets greater execution advantages. Meanwhile, at the CME/CBOT, market-makers also commit to providing liquidity to get execution costs reduced, but I don't think they a lot of the other advantages specialists get.
IMHO this comes down to a GRE degrees analogy:
beer drinker:beer snob::market-maker:specialist.
Note: all of my answers relate to the options markets.
IP has it right. A specialist, spec, or "DPM" (designated primary market maker) is the single market maker who is legally obligated to give quotes on the product for 99-ish% of the day. In return for this obligation, the spec essentially gets advantages in execution. Think of it like this: they get the best opportunity to quote on whatever product they are specialist for.
Anyone who is registered as such and gives both buy and sell side quotes is technically a market-maker, but these normal market makers don't have nearly as strict quoting requirements, i.e. as long as they never start quoting a product, they don't have to be quoting for any percentage day if they don't want to. However, if they do quote the product at least once, then they do have to respect some regulations in terms of minimum quoting standards -- but they are much less stringent than a spec's quoting standards.
Hope this helps.
I appreciate the responses guys, those were helpful explanations. A few follow up questions:
Are specialists employed by Investment Banks, or by the NYSE? I'm assuming that a specialist is basically responsible for only a couple of securities, i.e. theres one specialist for FORD or IBM on the floor.
(This one could be unanswerable) How do market makers decide what stocks they should provide liquidity for? Is it solely based on the demand of their clients?
I realize traders have to hedge their risk base on the trades they put on their books...how complicated is it to do this when they are just trading common stock securities? What different ways can they hedge their risk? Im sure its much more complicated when it comes to derivs etc....
Thanks!
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