The market maker explained
Have you ever come across the term market maker? In the context of stock exchanges, it’s a term that many people might have already heard without being able to really explain what a market maker is or does. At lemon.markets, we think it’s important to thoroughly grasp the players on the stock exchange(s) and their roles. That’s why we want to address these uncertainties in this article and explain everything you need to know about market makers. Let’s get started!
In order to better understand what a market maker is, we will focus on answering the who, how, why and what when it comes to market makers.
A market maker is an entity whose goal it is to provide liquidity to markets in order to guarantee that a security can be traded steadily. In many cases, upon placing a market order during trading hours, it is immediately or very quickly executed. That’s because there’s liquidity on the stock exchange. In order to buy a financial instrument, it must be offered by a seller (and vice versa: to sell an instrument, there must be an interested buyer). However, this may not always be the case at any given moment in time. That’s where market makers come in: they ensure that these trading opportunities exist and the market functions as intended.
In many cases market makers are brokerage houses, institutions or large banks — you might’ve heard of Deutsche Bank, Morgan Stanley or UBS. Even though it’s possible, it’s much less common for an individual to take on this role because a large amount of capital is required to perform market making activities.
Imagine you want to buy a few shares of Tesla at market price, but everyone is HODL-ing (‘holding on for dear life’).* You still want to get in on the trading action, so what now? A market maker will ensure that there (always) exists a trading opportunity (again, providing liquidity in the market), allowing you to purchase however many Tesla shares you wish.
But, if no one is selling, that probably means there’s some unanimous public consensus about the stock price, so why should a market maker not jump on the bandwagon? A market maker does not care about nor profit from directional movement (i.e. whether a stock goes up or down). Instead, they profit from the bid-ask spread of a particular financial instrument, which is the difference between what it can be bought for and what it can be sold for.
A market maker commits to constantly quoting the prices at which it is willing to buy (bid price) and sell (ask price) securities for which they make a market (i.e. provide liquidity). When a market maker receives your Tesla buy order, they immediately sell you these shares such that your trade can be completed. This happens even if they don’t own the shares and don’t have someone from which to purchase these shares lined up. Market makers can build up a (small) short or long inventory, because, most likely, an interested seller or buyer will come along eventually. Yet, this is not guaranteed, and for that reason, market makers are compensated for the risk taken to assume (in this case) a short position in Tesla.
You’ll see this compensation through the bid-ask spread. A market maker might sell you Tesla at €963 per share, but purchase it for €962, thus making €1 profit on each share. So, why doesn’t everyone do this? There is no guarantee that the price will not move in an undesirable direction between buying and selling. In this scenario this would mean that, before the market maker can resolve its short position, the price would’ve gone up to, for example, €964. Thus, €1 loss is incurred for each share.
To summarise in short, if there is no willing counter-party to fulfil your trade, a market maker will alway be there for you. 🤗
* Keep in mind, this is a highly hypothetical scenario and, likely, there will always be buyers or sellers for Tesla stock.
At what price? 💰
In general, market makers cannot set their prices arbitrarily. Instead, the market demand dictates where market makers set their bid and ask prices.
You’ll notice that in highly liquid markets, ones where people are steadily buying and selling, there is a tighter bid-ask spread (small difference) than in illiquid ones. You can see this as higher compensation needed for making an illiquid/volatile market.
The job of a market maker is to ensure a smoother flow of financial markets because you make it easier for investors & traders to make orders. Without a market maker there would be insufficient transactions and fewer investment activities in markets. Especially in times of volatility, the constant demand and supply offered by market makers is what keeps the market functional.
While operating at exchanges, market makers need to consider an exchange’s bylaws, which are approved by the country’s securities regulator, like the Security and Exchange Commission (SEC) in the USA. Its main purpose is to prevent market manipulation through law. Generally, the rights and responsibilities of market makers vary by exchange and by the type of the financial instrument they’re trading (equities, options…) as well.
For example, in the Regulated Market Maker Handbook from Deutsche Börse, registered market makers are required to provide, on average, quotes for at least one instrument during 50% of daily trading hours. Additionally, the size of bid-ask orders may not be more than 50% away from each other. This latter point makes sense because it could cause low liquidity and high volatility. You must know: if liquidity isn’t good, you can not make an ordinary market order.
To round this article up, we can say that market makers are crucial to ensure that financial markets, i.e. stock exchanges, offer smooth order execution for investors. By taking the risks, market makers ensure that instruments can be bought or sold whenever a participant in the market wants to do so.
I hope you enjoyed learning more about the concept of market makers and the stock market in general. If you want to learn more about financial markets, algo trading or FinTech in general, make sure to follow us. And if you are interested in in building your own trading application with an easy-to-use trading API, sign up to lemon.markets here. We’d be happy to have you on board. Any questions? Join our Slack community.