Market Maker
A market maker commits to maintaining active trading on the exchange platform by entering into transactions with other market participants.
Under the terms of its contract with the exchange, a market maker takes on obligations to help maintain price stability and the balance of supply and demand for financial instruments, currencies, or other commodities.
A market maker on the stock exchange acts as both a seller and a buyer at the same time, helping other traders avoid waiting for a counterparty and instead quickly buy or sell stocks, bonds, and other securities. The key task of a market maker is to maintain the liquidity of instruments and support active trading.
Types of Market Makers
An institutional market maker is a professional market participant (for example, a bank or a large fund) whose activities are aimed at maintaining a balance of supply and demand for a financial instrument. This type of market maker monitors trading volumes as part of its obligations under the current agreement. Often, the exchange itself publishes a list of such market makers, showing which instruments or markets each one covers.
A speculative market maker often operates in markets that have no centralized trading venue (the Forex market, the interbank lending market, etc.). A speculative market maker can influence quotes because of the large trading volumes it handles.
Functions of a Market Maker
The market maker performs several important functions:
- Acts as an intermediary between the buyer and the seller. The market maker helps other market participants buy and sell financial instruments faster.
- Provides liquidity. Exchange liquidity is supported by the transactions the market maker continuously makes.
- Maintains stable prices for financial instruments. A market maker helps close a deal with other market participants when the seller of a particular instrument cannot find a buyer.
- Supports trading volume on the stock exchange. The market maker helps to ensure active trading in a financial instrument so that the number of transactions meets the exchange’s standard. To do this, the exchange gives the market maker access to the order book, which contains all purchase and sale orders for a given instrument, so that the transaction is as favorable as possible for both the seller and the buyer. For example, in a situation where there is no buyer for a sell order, a market maker can act as that buyer. It also sees pending orders, stop-loss levels, and take-profit levels.
How Does a Market Maker Make Money?
- Receives a reward from the exchange. An institutional market maker earns income according to the agreement it has concluded with the venue where it operates. This income can be a commission on each transaction it makes; to qualify for it, the market maker must meet contract terms such as:
- Carrying out the minimum agreed number of transactions per day.
- Placing a minimum number of orders to maintain two-way quotes.
- Keeping the spread on two-way quotes within the maximum allowed level.
- Maintaining two-way quotes for the required minimum period for each instrument.
- Earns income from the spread and turnover. Using a set spread, the market maker places orders for the purchase and sale of securities, thereby increasing its turnover.
In a stable market, market participants buy securities from a market maker and later sell them back to the market maker at close to the same price. In an unstable market, the market maker must buy instruments whose price is falling (and the spread on them typically widens). When demand increases, it can sell securities at a wider spread.
To increase its income, the market maker uses trading algorithms based on order-placement data and the strategies of major market players.
As a result, the market maker calculates the optimal lot size and tick size. Other players also watch the market maker’s activity and factor its strategy into their own trading decisions.
- Makes money on arbitrage transactions. For example, a market maker adds liquidity to a futures contract and can also trade its underlying asset. This reduces its own risk, and if the futures price deviates significantly from the price of the underlying asset, the market maker can profit by holding the position until prices between the two instruments converge again.
The same situation occurs when the same asset is priced differently in different markets and the company acts as a market maker in one of them.
How to Determine Whether a Company Is a Market Maker
Exchanges generally provide access to lists of the market makers operating on their platforms. There you can find a market maker for investing purposes and review stock recommendations. The exchange provides data such as the market maker’s obligations, the terms of its contract, the company’s name, and the trading sessions in which the market maker company operates.
Why Does an Investor Need Knowledge About a Market Maker?
- The market maker makes a large number of transactions and, accordingly, helps to avoid price gaps for exchange instruments.
- The market maker helps to provide additional liquidity when needed by keeping quotes within a certain range to maintain a stable price.
- The presence of a market maker on the stock exchange inspires investor confidence, since investors can trade faster and at a fair price.
- In times of volatility, the market maker provides liquidity and depth, unlike other players who cannot offer them.
- The market maker contributes to the reliable operation of markets and their stability even in times of instability.