What Is a Market Maker?

With these transactions, commonly known as "principal trades" market makers can enter and adjust quotes to buy, sell, execute and clear orders.

Market makers must operate under a given exchange's bylaws, which are approved by a country's securities regulator, such as the Securities and Exchange Commission in the U.S. Market makers' rights and responsibilities vary by exchange, and by the type of financial instrument they are trading, such as equities or options.

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Role Of A Market Maker

Understanding Market Makers

The most common type of market maker is a brokerage house that provides purchase and sale solutions for investors, in an effort to keep 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, the vast majority of market makers work on behalf of large institutions.

Key Takeaways

  • A market maker is a individual market participant or member firm of an exchange that also buys and sells securities for its own account, at prices it displays in its exchange’s trading system, with the primary goal of profiting on the bid-ask spread, which is the amount by which the ask price exceeds the bid price a market asset.
  • The most common type of market maker is a brokerage house that provides purchase and sale solutions for investors, in an effort to keep financial markets liquid.

"Making a market" signals a willingness to buy and sell the securities of a defined set of companies to broker-dealer firms that are member firms of that exchange. Each market maker displays buy and sell quotations for a guaranteed number of shares. Once an order is received from a buyer, the market maker immediately sells off his position of shares from his own inventory, to complete the order. In short: market making facilitates a smoother flow of financial markets by making it easier for investors and traders to buy and sell. Without market making, there may be insufficient transactions and less overall investment activities.

A market maker must commit to continuously quoting prices at which it will buy (or bid for) and sell (or ask for) securities. Market makers must also quote the volume in which they're willing to trade, and the frequency of time it will quote at the Best Bid and Best Offer (BBO) prices. Market makers must stick to these parameters at all times, during all market outlooks. When markets become erratic or volatile, market makers must remain disciplined, in order to continue facilitating smooth transactions.

How Market Makers Earn Profits

Market makers are compensated for the risk of holding assets, because they may see a decline in the value of a security after it has been purchased from a seller and before it's sold to a buyer. Consequently, market makers commonly charge the aforementioned spread on each security they cover. For example, when an investor searches for a stock using an online brokerage firm, it might observe a bid price of $100 and an ask price of $100.05. This means that the broker is purchasing the stock for $100, then selling it to prospective buyers for $100.05. Through high-volume trading, small spread adds up to large daily profits.