Market makers are trading firms that continuously provide prices at which they will buy or sell assets.
Market makers are typically banks, brokerage firms or proprietary trading firms. Unlike traditional investors, they’re not in the business of betting whether the price of an asset will go up or down. They also don’t tend to hang on to securities for very long. Instead, market makers profit off the tiny price spreads that come from buying and selling securities rapidly.
Because they stand ready to do both sides of a trade, market makers are considered to be liquidity providers. Liquidity is the ease with which an asset can be bought or sold without affecting its price.
In both stock and equity options trading, there are at least a dozen different exchanges. In order to provide prices across multiple exchanges, market makers rely on algorithms and ultra-fast computer systems to make sure their price quotes reflect the supply and demand for a security in the market.
Because of their use of such technology, market makers are sometimes called high-frequency traders. Here’s a closer look at the role market makers play in financial markets today.
How Market Makers Earn Money
Market makers seek to profit off the difference in the bid-ask spread, or the difference between the price at which an asset can be bought and the price at which it can be sold.
Overview of Bid-Ask Spreads
Here’s a hypothetical example of how market making works. Let’s say a firm provides a quote for $10-$10.05, 100×200. That means they’re willing to buy 100 shares for $10, while simultaneously offering to sell 200 shares at the price of $10.05. The first part of the offer is known as the bid, while the latter is known as the ask. The prices that market makers set are determined by supply and demand in the market.
This means an investor or broker executing on behalf of a client can buy shares from the market maker at $10.05. And another investor looking to sell shares, can do so at $10 to this market maker. The difference of 5 cents is how the market maker locks in a profit. While making pennies on each trade sounds miniscule, it can be massively profitable at huge volumes.
Bid-ask stock spreads tend to narrow when markets are more liquid and widen when markets are less liquid. This is because during periods of volatility, sellers are more inclined to sell while buyers are more likely to stay put, anticipating lower prices in the near future. Because bid-ask spreads tend to widen during periods of stock volatility, it also means market makers are able to capture bigger profits when markets are turbulent.
Because of the risk of holding onto securities while making markets on them, market makers often hedge their bets by getting exposure to other assets or shorting securities in separate trades.
Overview of Payment for Order Flow
Another way some market makers earn revenue is through a practice known as payment for order flow. This is when retail brokerage firms send retail client orders to market makers who then execute the orders.
So let’s say for example, a mom-and-pop investor at home puts in a buy or sell trade via their brokerage account. The broker then bundles that order with other client orders and sends them to an electronic market making firm, which then fulfills the orders.
Market makers pay fees to brokerage firms for sending those orders, and this is how brokerage firms have been able to offer zero-commission trading to retail clients in recent years.
Payment for order is common and legal, but it’s come under controversy over the years with some critics saying the practice incentivizes brokers to boost revenue, rather than find the best prices for their customers. Market makers are required by regulatory rules to execute client orders with “best execution, “ but execution quality can be defined by price, speed or liquidity.
Defenders of PFOF argue that retail investors get “price improvement,” when customers get a better price than they would on a public stock exchange. A Bloomberg Intelligence report estimated that retail investors in 2020 benefited from price improvement by $3.7 billion. Separately, brokers are required by Securities and Exchange Commission regulation to make available statistics on execution quality, in what’s known as 605 and 606 disclosures.
What Are Designated Market Makers (DMMs)?
Designated market makers are trading firms on the New York Stock Exchange who are in charge of ensuring orderly trading of stocks listed on the New York Stock Exchange. Each company that chooses to list on the Big Board picks a DMM for its shares.
DMMs are supposed to add a human touch to stock exchange trading in today’s electronic markets. In contrast, the Nasdaq Stock Exchange, the second-biggest venue for U.S. equities, doesn’t have DMMs for its listed companies and trading is instead completely electronic.
Famous for wearing distinctive blue-colored jackets on the floor of the NYSE, DMMs used to be known as “specialists” back in the day. There used to be dozens of specialist firms in the 1980s, but these days there are just a handful of DMMs active on the NYSE floor.
Market makers are intermediaries who provide prices all day in two-sided markets, where both bids to buy and offers to sell are quoted. Instead of making long-term bets on whether an asset will rise or fall, they make money from holding on to assets for short periods and profiting off their tiny bid-ask spreads. Market makers rely on high volumes in order to generate significant revenue.
Market makers are also sometimes called high-frequency traders because they use ultra-fast technology and algorithms to connect to multiple exchanges and quote numerous prices continuously. They’re considered important participants in modern financial markets because they speed up the pace at which transactions take place, particularly in stock and equity options trading.
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