What is a Market Maker
A market maker is a "market participant" or member firm of an exchange that also buys and sells securities at prices it displays in an exchange’s trading system for its own account which are called principal trades and for customer accounts which are called agency trades. Using these systems, a market maker can enter and adjust quotes to buy or sell, enter, and execute orders, and clear those orders. Market makers exist under rules created by stock exchanges approved by a securities regulator. In the U.S., the Securities and Exchange Commission is the main regulator of the exchanges. Market maker rights and responsibilities vary by exchange, and the market within an exchange such as equities or options.
Role Of A Market Maker
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 or work for large institutions.
"Making a market" means 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 from its own holdings or inventory of those shares to complete the order.
Thus, market making enables the smooth flow of financial markets. Without this, investors and traders would not be able to buy and sell as easily. Less transactions in a market naturally translates to less investing, overall. Investing less would reduce funds available to companies and tend to decrease prices of shares of smaller companies without as wide a base of investors.
Exchange rules often have more than one category of market maker. Within the rules, a market maker firm can decide to commit to more responsibility for the smooth market performance of the specific securities in which it agrees to make a market. The market maker’s commitments include continuously quoting prices at which it will buy or bid, and sell or ask for securities. Market makers also have to quote the volume in which it is willing to trade and the frequency of time it will quote at the Best Bid and Best Offer (BBO) prices, and how it will do all of the above during all kinds of market hours and conditions. When markets become erratic or volatile, market makers need to keep a cool head to facilitate smooth transactions.
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 a bid price of $100 and an ask 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.