What Is a Market Maker (MM)?

A market maker (MM) is a firm or individual who actively quotes two-sided markets in a security, providing bids and offers (known as asks) along with the market size of each.

For instance, a market maker in XYZ stock may provide a quote of $10.00-$10.05, 100x500. This means that they bid (they will buy) 100 shares for $10.00 and also offer (they will sell) 500 shares at $10.05. Other market participants may then buy (lift the offer) from the MM at $10.05 or sell to them (hit the bid) at $10.00. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.

Market makers may also make trades for their own accounts, which are known as principal trades.

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.
  • 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.
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Role Of A Market Maker

Understanding Market Makers

Many market makers are often brokerage houses that provide trading services for investors in an effort to keep financial markets liquid. A market maker can also be an individual trader (known as a local), 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.

"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.

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.

Market Makers vs. Specialists

Many exchanges utilize a system of market makers, each competing against one another to set the best bid or offer in order to win the business of orders coming in. But some, like the New York Stock Exchange (NYSE) have a specialist system instead. The specialists are essentially lone market makers with a monopoly over the order flow in a particular security or securities. Because the NYSE is an auction market, bids and asks are competitively forwarded by investors. The specialist posts these bids and asks for the entire market to see and ensure that they are reported in an accurate and timely manner. They also make sure that the best price is always maintained, that all marketable trades are executed, and that order is maintained on the floor.

The specialist must also set the opening price for the stock each morning, which can differ from the previous day's closing price based on after-hours news and events. The specialist determines the correct market price based on supply and demand.