Understanding Market Makers: How They Fuel Liquidity

Market maker refers to a firm or an individual that engages in two-sided markets of a given security. It means that it provides bids and asks in tandem with the market size of each security. A market maker seeks to profit off of the difference in the bid-ask spread and provides liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. to financial markets.

Summary

• Market maker refers to a company or an individual that engages in two-sided markets of a given security.
• A market maker seeks to profit off of the difference in the bid-ask spread.
• The purpose of a market maker in a financial market is to keep up the functionality of the market by infusing liquidity.

Market Maker – Example

Consider a situation where a market maker in stock alpha can provide a quote for $5-$5.50, 100×200. It means that they want to buy 100 shares for the price of $5 while simultaneously offering to sell 200 shares of the same security for the price of $5.50. The offer to buy is known as the bid, while the latter offer to sell is the ask.

Other participants in the market have the option of lifting the offer from the market maker at their ask price, i.e., $5.50. It means that they can buy from the market maker at the given price. They can also hit the bid or sell to them for their bid price, which is $5.

The difference of $0.50 in the ask and bid prices of stock alpha seems like a small spread. However, small spreads, as such, can add up to large profits on a daily basis, owing to large volumes of trade.

What Entities Act as Market Makers?

A market maker can either be a member firm of a securities exchangeNew York Stock Exchange (NYSE)The New York Stock Exchange (NYSE) is the largest securities exchange in the world, hosting 82% of the S&P 500, as well as 70 of the biggest or be an individual market participant. Thus, they can do both – execute trades on behalf of other investors and make trades for themselves.

When they participate in the market for their own account, it is known as a principal trade. When a principal trade is made, it is done at the prices that are displayed at the exchange’s trading system. The bid-ask spread is the total profit made by the maker. A bid-ask spread is the difference between the amounts of the ask price and bid price, respectively.

For instance, in the above example, the bid-ask spread is the difference between $5.50 and $5. The total profit made by the market maker is $50 ($5.5 * 200 – $5 * 100 – $5.5*100).

The most common example of a market maker is a brokerage firm that provides purchase and sale-related solutions for real estate investors. It plays a huge part in maintaining liquidity in the real estate market.

Usually, a market maker will find that there is a drop in the value of a stock before it is sold to a buyer but after it’s been purchased from the seller. As such, market makers are compensated for the risk they undertake while holding the securities.

Why are Market Makers Important?

The purpose of market makers in a financial market is to keep up the functionality of the market by infusing liquidity. They do so by ensuring that the volume of trades is large enough such that trades can be executed in a seamless fashion.

In the absence of market makers, an investor who wants to sell their securities will not be able to unwind their positions. It is because the market doesn’t always have readily available buyers.

If a bondholder wants to sell the security, the market maker will purchase it from them. Similarly, if an investor wants to purchase a given stockStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably., market makers will ensure that shares of that company are available for sale. Thus, they act as wholesalers in financial markets.

The prices set by market makers are a reflection of demand and supply. Stockbrokers can also perform the function of market makers at times. It, however, represents a conflict of interest because brokers may be incentivized to recommend securities that make the market to their clients.

Learn More

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• Sources of LiquiditySources of LiquidityFor a company, its sources of liquidity are all the resources that can be used to generate cash. There are generally two major classes of sources of
• Bid and AskBid and AskThe term bid and ask refers to the best potential price that buyers and sellers in the marketplace are willing to transact at.
• Spread TradingSpread TradingSpread trading – also known as relative value trading – is a method of trading that involves an investor simultaneously buying one security and selling a
• Investment MethodsInvestment MethodsThis guide and overview of investment methods outlines they main ways investors try to make money and manage risk in capital markets. An investment is any asset or instrument purchased with the intention of selling it for a price higher than the purchase price at some future point in time (capital gains), or with the hope that the asset will directly bring in income (such as rental income or dividends).