What Is a Third Market Maker?

A third market maker is a type of market maker that deals in the third market, which is a segment of the financial markets in which exchange-traded securities are exchanged over-the-counter (OTC) by institutional investors.

The term can also be used in a more general sense to refer to any third-party securities dealer who is ready and willing to trade stocks listed on exchanges at publicly traded prices.

Key Takeaways

  • Third market makers are market makers operating in the third market of the financial world.
  • The third market consists of large investors who trade seasoned securities on an OTC basis as opposed to directly with an exchange.
  • Third market makers hold their own inventory of securities, and they aim to profit by reselling that inventory at a higher price. In doing so, they contribute to the overall liquidity of the marketplace.
  • Market makers are willing to purchase inventory if there is not an additional buyer or seller immediately available for that security, thereby assuming some of the inventory risk of the marketplace.
  • Because third-market makers usually trade in large blocks of securities, trading is primarily limited to large investors, such as pension funds and hedge funds.

Understanding a Third Market Maker

As their name suggests, third market makers operate in the so-called third market. In this segment of the financial markets, broker-dealers and institutional investors trade large block orders of stock with one another, often bypassing the need for brokerage commission fees. Trading in this market is typically limited to large investors, such as pension funds, hedge funds, and other financial institutions.

The third market supports the primary and secondary markets. Whereas the primary market relates to the issuance of new securities through initial public offerings (IPOs), the secondary market is where more established or "seasoned" securities are traded. The third market can be seen as an ancillary to the secondary market, in that it involves OTC transactions of seasoned securities by institutional investors.

When third-market trading began, it was a way for investors to achieve anonymity, shielding their purchases from public view, which they could not obtain from directly trading on the exchanges. Third-market trading also allowed financial institutions to negotiate fixed commissions; lower than the fixed commission charges on exchanges, making investing more cost-friendly, helping to improve trading profits.

Third Market Trading

Third market trading was pioneered in the 1960s by firms such as Jefferies & Company. Today, however, there are a number of brokerage firms focused on third market trading. More recently, so-called dark pools of liquidity have also become popular, particularly among high-frequency trading (HTF) firms.

As with all market makers, the market makers that operate in the third market provide liquidity to the marketplace by facilitating the purchase and sale of securities. They do so by purchasing an inventory of securities for their own account, which they hold and then resell to other market participants. 

Market makers generate profit by buying low and selling high, and they are willing to purchase inventory if there is not an additional buyer or seller immediately available for that security afterward. For this reason, market makers assume some of the inventory risk of the marketplace; if demand for their inventory diminishes before it can be resold, market makers may realize a loss upon the sale of that inventory.

Example of a Third Market Maker

Sean is a market operator operating in the third market. As such, he deals mainly with large institutional counterparties who wish to make OTC transactions in securities that typically trade in the secondary market. Because these large inventors trade directly with one another, they can often avoid paying any commission fees.

To profit from these transactions, Sean acts as a market maker, buying his own inventory of securities and then reselling them to institutional counterparties at a higher price. These transactions generally involve large blocks of shares that exchange hands. 

Because Sean holds inventory in these shares, it is possible for him to lose money if he fails to find a buyer within a reasonable timeframe. Therefore, having a keen knowledge of the institutional marketplace is essential for Sean's long-term success as a third market maker.