A Market Maker (also known as a liquidity provider) refers to a company, firm, or individual that actively quotes two-sided markets in security. They do this by providing bids and offers (also referred to as ‘asks’) in tandem with the market size of each. This is done in the hope of earning a profit on the bid-ask spread.
What this means is that market makers provide quotes on a stock of around $10.05, buying around 100 shares for $10, and then making a profit off the excess. Other traders or investors may buy shares at a rate of $10.05 or sell to them at a rate of $10.
Should an investor wish to buy shares in Apple, for example, they would need to find someone who is willing to sell their shares. Given the current market, it is unlikely to find someone immediately.
This is where the role of the market maker comes in. It is either a company or firm that is always ready to buy or sell 100 shares of any stock at any time at a publicly quoted price.
Market makers also provide financial liquidity to investors or traders.
Key Takeaways:
- Market makers engage in two-sided markets in any given security
- Market makers aim to profit from the difference in the bid-ask spread
- Market makers aid in financial market liquidation
- Market makers aid in maintaining the current trading volume by allowing for trade on demand
The Role of Market Makers
Market makers, as the name suggests, ‘make markets’ and allow traders to buy and sell
stock whenever they wish. By offering traders the freedom to trade as they want,
market makers allow for the seamless operation of financial markets.
They also
keep up the functionality of the market by allowing for financial liquidation.
Without it, the risks associated with trade and investment would increase.
Without market makers, the current financial market would be unable to operate at its current rate. This would reduce the money companies have access to and thus, would lessen their value.
In addition, the prices set by market makers reflect the supply and demand of the market. With their willing buyer willing seller approach, market makers aid in maintaining consistency within the financial market.
Who Acts As Market Makers?
Market makers come in a variety of forms such as banks, financial firms,
organizations, or individual market participants.
They can also take on various
roles, as either trading on behalf of investors or trading for themselves. Trading
for themselves, known as principal trade, is done at the exchange trading systems’
prices.
Market makers trade as a brokerage firm. Brokerage firms provide services to real estate investors through purchase and sale-related solutions. Here too, market makers aid in maintaining real estate market liquidity.
Market makers are usually aware of dips in stock value before it is sold to a trader and after it has been bought. They undertake this risk while holding securities and are compensated for it.
How Do Market Makers Earn A Profit?
Providing trade on demand adds risks to their operations. An example of this is that a market maker could buy shares just before the stock begins to drop or being unable to find a buyer for the shares.
Market makers seek to earn a profit off the bid-ask spread. This acts as compensation for the risk they undertake when holding securities.
In order to earn on the bid-ask spread, market makers usually charge a spread on each security they cover. Thus, the bid price may be advertised at $100 while the asking price could be $100.05.
The $0.05 would be the profit a market maker earns per share sold. Given the rapid rate at which stocks are bought and sold, those tiny spreads add up to substantial daily profits that could equal more than $300,000.
Exchange bylaws regulate market maker operations, and these are approved by the security regulator of a country. For example, the Securities and Exchange Commission in the US.
The rights and responsibilities of market makers can vary depending on the exchange and financial instruments they are trading in.
Market Makers VS Specialists
Another role that a Market maker can take on is that of a Designated Primary Market Maker (DPM). A DPM is approved and sometimes employed, by an exchange in order to guarantee that they will buy or sell a particular security or option.
They are more commonly known as specialists. Specialists operate on a particular exchange and they fulfill a similar role as that of independent market makers.
They are employed by large stock exchanges, such as the U.S Stock exchange, in order to aid with financial market liquidity. Specialists are also required to take sides on trades when there are imbalances within the market.
In return, they are offered valuable information and advantages in trade execution.
Conclusion
Market makers play an essential role in the operations and stability of financial markets.
By operating on a ‘trade on-demand’ basis, they aid in the liquidity of financial markets. This also allows for a seamless trading experience for investors and aids in keeping financial markets operating smoothly.
While market makers undertake risks while holding securities, they are compensated for this by earning a profit from bid-ask spreads. Spreads can be charged at $0.05 per share.
$0.05 may seem like a small amount but give the active trading environment, this can lead to a large daily profit.
There are also market makers called Specialists, who are employed by exchanges. Specialists trade in a specific exchange and aid in maintaining market stability and financial liquidation.
