A market maker or liquidity provider is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.
A Designated Primary Market Maker (DPM) is a specialized market maker approved by an exchange to guarantee that he or she will take the position in a particular assigned security, option or option index.
In currency exchange
Most foreign exchange trading firms are market makers and so are many banks. The market maker sells to and buys from its clients and is compensated by means of price differentials for the service of providing liquidity, reducing transaction costs and facilitating trade.
In stock exchange
Most stock exchanges operate on a "matched bargain" or "order driven" basis. When a buyer's bid price meets a seller's offer price or vice versa, the stock exchange's matching system decides that a deal has been executed. In such a system, there may be no designated or official market makers, but market makers nevertheless exist.
In the United States, the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), among others, have Designated Market Makers, formerly known as "specialists", who act as the official market maker for a given security. The market makers provide a required amount of liquidity to the security's market, and take the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders. In return, the specialist is granted various informational and trade execution advantages.
Other U.S. exchanges, most prominently the NASDAQ Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability to naked short a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting. Recent changes to the rules have explicitly banned naked shorting by options market makers.
On the London Stock Exchange (LSE) there are official market makers for many securities. Some of the LSE's member firms take on the obligation of always making a two-way price in each of the stocks in which they make markets. Their prices are the ones displayed on the Stock Exchange Automated Quotation (SEAQ) system and it is they who generally deal with brokers buying or selling stock on behalf of clients.
Proponents of the official market making system claim market makers add to the liquidity and depth of the market by taking a short or long position for a time, thus assuming some risk in return for the chance of a small profit. On the LSE one can always buy and sell stock: each stock always has at least two market makers and they are obliged to deal.
In contrast, on smaller, order-driven markets such as the JSE Securities Exchange it can be difficult to determine the buying and selling prices of even a small block of stocks that lack a clear and immediate market value because there are often no buyers or sellers on the order board.
Unofficial market makers are free to operate on order driven markets or, indeed, on the LSE. They do not have the obligation to always be making a two-way price but they do not have the advantage that everyone must deal with them either.
Prior to the Big Bang, jobbers had exclusive rights of market making on the LSE.
The Frankfurt Stock Exchange runs a system of market makers appointed by the listed companies. These are called "designated sponsors". Designated Sponsors secure higher liquidity by quoting binding prices for buying and selling the shares. The largest market maker by number of mandates in Germany is Close Brothers Seydler.
How a market maker makes money
A market maker aims to make money by buying a stock at a lower price than the price at which they sell it, or by selling a stock at a higher price than the price at which they buy it back. Ordinarily, they can make money in both rising or falling markets, by taking advantage of the difference between "bid" and "offer" prices.
Stock market makers also receive liquidity rebates from electronic communication networks (ECN) for each share that is sold to or purchased from each posted bid or offer. Conversely, a trader who takes liquidity from a bid or offer posted on an ECN is charged a fee for removing that liquidity.
A market maker's profitability is a function of the level of informed trading in the market. Uninformed traders have no private information, only public information already reflected in the price of the security. The direction they trade in has no statistical relationship to the future movement of the price. In contrast informed traders have private information, the direction they're trading in reflects the likely future direction of the stock. Since market makers stand ready to simultaneously buy or sell they're the primary counter-party to informed traders. In the absence of informed traders market makers would in the long-run earn the bid-ask spread over every share they trade (plus any relevant liquidity rebates or exchange fees). However the inventory position market makers build up over time is inversely related to the direction informed traders are trading in. If most insiders are selling market makers tend to be net long, and if most are buying market makers tend to be net short. Since informed traders by definition predict the direction of the stock price, on average the positions market makers hold will decay in value over time. This phenomenon is termed adverse selection.
In economic equilibrium market makers will set the bid-ask spread to compensate them for the costs of adverse selection (plus some amount for their operational and capital costs). Thus bid-ask spreads are a function of the level of informed trading in the market at that time. More informed trading will widen bid-ask spreads, which increases transaction costs for uninformed traders. Ultimately uninformed traders bear the cost of informed traders even though they tend not to trade directly with each other as counter-parties.
- Sales and trading
- Day trading
- List of finance topics
- Divide and choose, analogous to a two-way price
- Radcliffe, Robert C. (1997). Investment: Concepts, Analysis, Strategy. Addison-Wesley Educational Publishers, Inc. p. 134. ISBN 0-673-99988-2.
- Market Maker Definition
- Associated Press (July 27, 2009). "‘Naked’ short-selling ban now permanent". NBCNews.
- Barker, Alex (October 19, 2011). "EU ban on ‘naked’ CDS to become permanent". Financial Times. Retrieved 27 September 2012.
- "List of U.S. market makers". Retrieved 2008-10-31.
- "List of market makers in Canada". Retrieved 2008-10-31.