Market Maker

What is a Market Maker?

A market maker is a broker-dealer firm that facilitates trading in assets like stocks, bonds, commodities, and derivatives. They achieve this by always being ready to take the other side of a trade by selling from their inventory at the ask price or buying into inventory at the bid price. Their willingness to hold positions gives market makers the ability to provide constant bid and ask price quotes.

Roles and Functions of Market Makers

The primary role of market makers is to ensure there is sufficient liquidity and an orderly market by standing ready to buy and sell a particular security on a continuous basis. They enhance price discovery and efficiency by taking on temporary imbalances of buyer and seller interest. Other key functions include making tight, competitive bid-ask spreads and maintaining an inventory of securities to meet obligations.

Types of Market Makers

There are various types of market makers based on asset class, exchange designation, trading style, etc. For example, designated primary market makers on stock exchanges, market makers specializing in over-the-counter trading, regional trading firms making markets in specific products, automated market making systems using algorithms, and more.

Market Maker Quotes and Spreads

Market maker quotes consist of bid and ask prices they are willing to buy or sell a certain quantity of the traded instrument. Their compensation comes from the bid-ask spread, which is the difference between the sell (ask) and buy (bid) price quotes. Tighter, liquid spreads indicate a more efficient market. Factors like volatility impact the spread width.

Market Maker Risks and Hedging

While profiting from spreads, market makers face significant risks from adverse price movements if they are carrying large unhedged positions. As such, they typically implement hedging techniques like taking offsetting positions in related instruments to mitigate exposure. Active risk management is critical given the large volumes and leveraged nature of their business.

Regulations for Market Makers

To ensure fair, transparent and orderly markets, exchanges impose requirements that designated market makers must maintain continuous two-sided quotes meeting maximum allowable spread criteria. There are also capitalization, reporting and other obligations around equity stakes or sharing inventory levels. Failing obligations can result in sanctions.

Major Market Maker Examples

Some major market making firms include companies like Citadel Securities, Virtu Financial, Jane Street Capital, Susquehanna International Group, and Jump Trading. Many leading banks also run major market making operations across various asset classes.

Market Maker Profitability

Market makers earn profits primarily from the bid-ask spreads they capture when facilitating trades by drawing from their inventory. The spread represents compensation for providing tradable quotes, taking on risk, and ensuring liquidity. Other revenue can come from fees, commissions, interest on cash holdings, and gains from hedging or speculative positions.

Alexander Voigt, CEO
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Alexander Voigt is the founder of DayTradingZ, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Investors.com, Capital.com, Business Insider and Forbes.