Who is a Market Maker – Their Role and Importance in Trading
Market makers are high-volume traders who buy and sell securities on behalf of large financial institutions or brokerage firms. They “make the market” by always being ready for trades. In this way, they provide necessary liquidity in an economy and help in improving trade and the volume of securities.
This article provides a closer view of who market makers are, how they work, their role and importance in the stock market, how they differ from brokers and more. Read on!
Who is a Market Maker ?
You can picture a market maker as a matchmaker in the stock exchange. They buy shares from one party and find suitable buyers with applicable requirements. Then, they sell these shares to them at a different price. This makes the stock market highly efficient, viable and liquid.
However, they must play their part ethically, abiding by the laws of the specific countries. As an important part of the economy, market makers follow the norms set by security regulators.
Market makers make trade from their accounts. This is known as principal trade. They provide depth and liquidity to the market while making profits from bid-ask spread differences.
How Does a Market Maker Work?
Market makers largely work by quoting bids and asking prices to sellers and buyers, respectively. They allow traders to trade their securities without much hassle whenever they want. As a result, market makers tend to maintain a stable demand even during price volatility. This helps maintain the buying and selling process running smoothly.
They are compensated for the risks of holding assets by profits from bid-ask differences. In other words, they can see the value of a recently bought security and charge a spread before selling it.
To understand the working of market makers in a flowing stock market, let’s picture the following example of a market maker.
Example of a Market Maker
Let’s consider you are willing to sell 100 shares of a company. Market makers will purchase all 100 shares from you at a bid price of Rs.100 each share. They will purchase these shares even when they have no sellers lined up.
Now, market makers have decided to impose an Rs.5 spread for each share and sell them at an asking price of Rs.105. The Rs.5 difference between the bid and ask price is the profit market makers earn from each share. This makes these shares immediately available for buyers.
Multiple market makers come to play for high-volume orders. This allows consistent liquidity in the economy.
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Who Can Become Market Makers?
A market maker can be an individual agent or broker, or a firm of security exchanges. These entities hold liquid cash they provide to investors or sellers during a trade. Foreign exchange dealers can also become market makers to buy or sell securities anytime.
Due to the size of transactions, most market makers work for large brokerage houses and financial institutions. However, there are some lone traders, called locals, who function as market makers.
What is the Role of a Market Maker in the Market?
The role of market makers in a stock market is given below:
- They give buying and selling quotes for a guaranteed number of shares
- Market makers facilitate liquidity and stability in the markets
- These traders play an important role in setting different ask prices and earning profit from the bid-ask spread
- These people must quote accurate values for bid/ask prices and volumes, regardless of the current economic conditions
- Market makers identify buyers and continue trading without a break. Thus, they keep the markets stay efficient all the time
How Market Makers Improve the Market?
Market makers help improve a country’s economy in these ways:
- They ensure free liquid flow as market makers are always ready to buy or sell shares from sellers even when they have no sellers or buyers to complete a transaction
- Market makers ensure that securities have enough trading volume to support today’s liquidity
- The two-way quotes of the market makers help reduce the trading risk and basis risk for players
- Market makers reduce market volatility as they provide fixed quotes
What is the Market-Making Process?
As the market makers are always available, it eases the sellers’ and buyers’ jobs of selling and purchasing stocks. They follow a simple market-making strategy to maintain liquidity in the market.
When market makers receive a lead about sellers with a fixed bid, the market makers communicate as buyers to purchase those shares. After owning those shares, market makers set an asking price based on market fluctuations. Their profit lies in the difference between those shares’ cost and ask price. Although this difference might seem very low if we consider each share, the large volume of such transactions leads to huge profits.
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Why Are Market Makers Important?
Market makers are essential as they ensure sufficient volume and liquidity to flow through the markets. In addition, sellers and buyers will always find their potential counterparts in the stock market whenever necessary. This ensures financial markets operate smoothly irrespective of the order size.
Without a market maker, a seller or buyer would have to wait for a suitable party for a longer period. Their absence from the market might lead to a collapse or break in the stock market.
How Automated Trading Enables Market-Making?
With the advancement of computer technology, automated market making is becoming more efficient daily. Their algorithms can efficiently detect risks and respond to such risky events better than humans. Automated trading algorithm enhances market-making in the following ways.
- Automated trading adjusts quotes immediately on a real-time basis. This pace is much faster than what humans can achieve.
- Market makers must react immediately to events like changes in the prices of financial instruments or trading positions that market makers accumulate. Automated technology executes trades much faster than humans.
With the help of automated trading algorithms, market makers enjoy the following benefits.
- Faster response time with instant and accurate calculations
- Automated money makers can work and track thousands of instruments simultaneously. In contrast, humans can only track a few numbers at the same time
- Machines do not need a break to rest their brain like humans. They can reply instantly at any given time. Therefore, you can expect 24×7 instant responses from automated trading algorithms.
What is the Difference Between a Broker and a Market Maker?
To compare brokers and market makers, we need to know who brokers are first.
Brokers are intermediaries who buy or sell assets for other people. They are a bridge that brings together sellers and buyers. In addition, brokers have sufficient expertise and authorisation to buy shares on the investor’s behalf.
Market makers are individual agents, financial institutions or banks that ensure liquid flow in the market. Unlike brokers who buy or sell on others’ behalf, they purchase or sell shares only when there is a lead.
Market makers sell shares to new buyers at a different ask price, usually higher than the bid price. The difference between ask and bid prices is the profit for market makers. However, brokers charge an extra amount as their commission. This implies that the larger a trade’s value, the higher the broker’s commission.
A market maker creates the ground for trade for every investor, while brokers perform trading on investors’ behalf. Investors can buy or sell securities in the market when facilitated by a market maker. In contrast, brokers deal with shares, ETFs and mutual funds.
Factors to Keep in Mind about Market Makers
Here are some important points you must remember about market makers:
- Brokerage houses are a popular form of market makers amongst investors. This is because brokerage houses offer other services like advice and insights about stocks which comes in handy for investors.
- They are also successful in bringing down time consumption that is involved in executing an order and transaction costs.
- Different stock exchanges have their unique structures of market makers. While some exchanges have market makers dealing with many securities, others employ a designated market maker for each security.
Final Word
To conclude, market makers are an essential component of the stock market which allows for ease of trading and exchange. Mechanical or automated market-making systems make this process more efficient and fast, ensuring a convenient experience for traders. There are a lot of rules and regulations that govern how a market marker should work.
FAQs
Ans: Market makers sell the securities at a price higher than the purchase cost. Their profit depends on the difference between the selling price and the cost price of securities. Therefore, they tend to manipulate the market as per their interest.
Ans: Market makers provide volume to stocks and prevent the market from collapsing or becoming illiquid. Thus, they make it safe for any investor to buy or sell securities at any time.
Ans: Yes, market-making is legal, sound and essential for a financial market to function efficiently. However, market makers need to follow the regulations set by the governing nation or state to avoid acting arbitrarily.
Ans: Not all brokerages are market makers. Brokerages function as intermediaries between sellers and buyers. On the other hand, market makers buy and sell securities as themselves and not representing any other party. Brokers cannot buy stocks for themselves. However, market makers can do so and sell these stocks at a higher price.
Ans: There is a thin line of difference between market makers and dealers. Both purchase stocks by quoting a bid and sell them at an asking price. However, dealers operate on over-the-counter markets, whereas market makers function in an exchange. This highlights that a market maker has more requirements to look after than a dealer.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
