Market makers and their importance in the financial markets
Sep 8, 2018
Written by: Al Hill
The term market makers is something you might have come across very often in the world of financial trading. Be it forex, stocks or futures, market makers form an integral part of the financial ecosystem.
Yet despite their importance, there is a lot of negativity and doubt that surrounds the word of market making. This report from the Economist details how at times even market makers can be cautious when the market churns.
Let’s take an example to understand what a market maker does.
What if you were in desperate need of cash and want to sell your car? You put an ad out no your local buy and sell website. But there is no one who is willing to match the price you want to sell the car for. You have just two choices.
You either have to end up lowering your asking price or you simply have to wait for the right bid that matches your offer.
A market maker, on the other hand, is a person or an institution that is ready to buy your car. Sure, their bid for the car will certainly be lower compared to your asking price. But at the very least you are able to offload your car and go to cash.
As you can see from the above example, there are some advantage and disadvantages to the deal.
The advantage is that you are able to readily convert your hard asset (the car) into cash through a market maker. The disadvantage is that you won’t quite get the price you are expecting.
So here in lies the dilemma. Do you hold on to your asset until you find a buyer matching your ask price? Or are you willing to take a hit on your bottom line and opt for getting cash in hand?
In the financial markets, a market maker plays a similar role. They facilitate a smooth flow of the financial markets.
Table of Contents
Who is a market maker?
A market maker is also known as a dealer. A market maker is a person or an institution that buys and sells securities for their clients. In some cases, it can be buying and selling securities from other firms or their client accounts.
A market maker usually is registered in an exchange such as the NASDAQ or the NYSE. They form an integral part of the financial ecosystem because they bring structure and order to the trading activity. You might wonder how a market maker is different from other roles on the trading roles.
You might have heard of other roles such as specialists or floor traders in trading. The main difference between a market maker and the rest is that their physical presence is not required. Market makers nowadays trade electronically.
They work through a system run by the National Association of Securities Dealers or NASD and this has been in place since 1971 since the NASDAQ started its operations. A market makers role in an exchange is to quote the buy and sell offers for a guaranteed number of shares.
Market makers are regulated by the securities regulator such as the Securities and Exchange Commission (SEC) in the United States.
The rights and responsibilities of the market maker can vary from one exchange to another and within different markets.
When price hits these levels, the market maker is ready to use their own inventory to take on or offload the securities from their inventory.
It might sound a bit tedious but all the trading and exchange of securities are done electronically and in a matter of a few milliseconds or nanoseconds.
How do Market Makers make money?
Before we delve into how market makers make money, it is important to understand that they also take a risk. The risk is in buying or offloading a security. For example, if a market maker buys a security, there is a risk that it will decline in value.
In other words, the buy and sell prices quoted by a market maker brings risk onto their trading books. While market makers enable a smooth flow of the financial markets, the risk is still on their books. In order to compensate for this risk, market makers charge a fee.
The fee comes in the form of commissions or generally the spread. In most cases, depending on the market participants dealing with the market makers, high volume clients such as brokerage houses are charged a fee.
For other regular participants, there is a spread that needs to be paid to the market maker. This ensures that the market makers are compensated for the risk. A market maker does not make money by buying low or selling high.
Market makers make money through the transactions they do and the spreads or commissions they earn.
What is the spread?
The spread is the difference between the bid and ask price. For example, a market maker will quote a bid price of $10 for a security while their asking price for the same security would be at $10.5. The spread is the difference between the bid and the asking price.
In the above example, you can see that the market maker’s spread is $0.50. Thus when they buy one share of the security, they buy at $10.00 and sell the same at $10.50 which gives them a $0.50 in profit. This profit is the compensation for the risk they take.
Usually, a security’s spread is higher when it is less liquid and the spread is lower when the security is more liquid.
What is the importance of market-making?
Market makers are important to maintaining the structure of an exchange and to ensure smooth flow of orders. The importance of market makers cannot be questioned as they bring the much-needed liquidity. This research paper, for example, gives conclusive evidence about market makers bringing more stability to the markets.
Having designated market makers on exchanges is more important than ever as market structure continues to change.
The importance of market makers also comes to the forefront in markets that deal with securities that are less liquid. The topic of market makers comes up at times surrounding a market crash. For example, the May 6th 2010 flash crash that sent all the three major U.S. stock indices into a plunge.
As liquidity dries up, leaving many players exposed to their positions, authorities have proposed tight regulations for the market makers. The most important aspect is that the market makers provide liquidity in times of market stress.
Despite playing an important role, algorithmic or high-frequency trading has been eating into the share of traditional market makers. With the rise of automated trading, there is the aspect of liquidity that helps to bring stability.
But at the same time, high-frequency trading can also play a big role in facilitating for market crashes that could have been avoided.
Misconceptions of market makers and market-making
Market makers usually carry a negative connotation. The most common myth being that market makers manipulate prices. However, manipulating prices is a very vague term. Sure, in one way a market maker does manipulate price by charging the spread.
There are also instances when a market maker can charge a higher bid or ask price simply to drive the price higher or lower. Prices can be moved around when the market maker has a motive to offload a risky bet on their books.
However, this “manipulation” is merely a compensation for the risk they carry, regardless of the time they hold the security. The misconception is even wider when it comes to retail online trading brokerages. The average retail investor is often cautious to trade with market makers. Instead, it is generally said to use a broker that executes your trades STP.
A very good example is the Swiss franc currency devaluation in January 2015. Most of the retail traders trading with a DMA (Direct Market Access) broker felt the pinch. As liquidity fell in the markets, traders were left holding the bag with not many willing to hit the bids.
On the other hand, those trading with a market maker were able to control their losses. With market makers, liquidity brought some stability as traders with bad positions were able to offload quickly.
Herein lies the importance of the role of market making.
Another aspect to bear in mind is that market makers do not blindly carry the risk. Whenever risk builds up significantly on a market maker’s trading book, they offset or hedge the risks. Thus, a market maker does not merely buy and sell but they also manage risk.
In most cases, unlike traditional investing which brings the aspect of hedging, market makers hedge solely to contain their risks. At any given time, a good market maker will be risk neutral. This means that they make profits based on the transactions and not on whether the security is moving up or down.
You are a market maker as well
By now you must have a clear understanding of what a market maker is. You might have also learned their importance in maintaining the integrity in the markets. Now onto the fun part!
If you are an active day trader, chances are that you are also a market maker in a way.
Take for example you bought 10 shares in Microsoft at $100.00. You place a limit order to sell 10 shares at $105.00.
Now, another trader comes in looking at the stock. The price is trading close to $105.00 and they hit your offer.
What is happening here is that you are charging a spread on your trade while also bringing liquidity to the market. Even if it means just 10 shares. You spread is basically the difference of the price where you bought and where you are selling, which is $105.00 – $100.00 = $5.00.
You might have your own reasons for selling the shares at $105.00 and the buyer has their own reasons.
All said and done, market makers are an important element to the structure of maintaining the integrity of an exchange. Market makers provide the much-needed stability and the liquidity to ensure a smooth order flow.
While there are some apparent downsides to being a market maker and dealing with a market maker, the pros certainly outweigh the cons. Market making is not a complex science as illustrated above. Even the average day trader in a way behaves as a market maker.