What is a 'Market Maker'
A market maker is a broker-dealer firm that assumes the risk of holding a certain number of shares of a particular security in order to facilitate the trading of that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares, and once an order is received from a buyer, the market maker immediately sells from its own inventory or seeks an offsetting order. The Nasdaq is the prime example of an operation of market makers, given that there are more than 500 member firms that act as Nasdaq market makers, keeping the financial markets running efficiently.
BREAKING DOWN 'Market Maker'
The most common type of market maker is a brokerage house that provides purchase and sale solutions for investors in order to keep the financial markets liquid. A market maker can also be an individual intermediary, but due to the size of securities needed to facilitate the volume of purchases and sales, almost all market makers are large institutions.
How Market Makers Facilitate Financial Transactions
Market makers hold large volumes of a security and can fulfill a large amount of orders in the financial markets. These orders are purchases and sales and happen in a matter of seconds. A good example of a market maker is a standard online brokerage firm such as Charles Schwab or Merrill Lynch that can fill security orders quickly and efficiently.
Essentially, market makers are always taking the opposite side of investor trading volume. If investors are looking to sell a security, for example, market makers continue to purchase that security until all sellers are satisfied. Conversely, if investors are buying a security, market makers continue to sell that security until all orders are filled. Market makers, therefore, satisfy the supply and demand of the financial markets and keep securities changing hands from sellers to buyers, and vice versa.
How Market Makers Earn Profits
All market makers are compensated for the risk of holding assets. The risk they face is a decline in the value of a security after it has been purchased from a seller and before it's sold to a buyer. Therefore, market makers charge a spread on each security that they cover. This is known as the bid-ask spread and is extremely common in financial transactions. For example, when an investor searches for a stock using an online brokerage firm, it might have an ask price of $100 and a bid price of $100.05. This means that the broker is purchasing the stock for $100 and then selling the stock for $100.05 to prospective buyers. Through high-volume trading, the small spread ads up to large daily profits.