What is a Market Maker?
A market maker is a firm or individual that actively quotes both buy and sell prices for a specific security, providing liquidity and depth to the market. They earn profits from the bid-ask spread and may also engage in principal trades, where they trade securities from their own accounts.
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Role of Market Makers
Market makers, often brokerage houses, ensure the smooth functioning of financial markets by maintaining liquidity. Individual market makers, sometimes known as locals, also participate but the majority work for large institutions due to the volume of securities required. Upon receiving an order, they immediately sell from their stock to complete the transaction.
Market makers must continuously quote prices at which they will buy (bid) and sell (ask) securities. They must adhere to the quoted volume and maintain these quotes consistently, even in volatile market conditions, to facilitate seamless transactions.
How Market Makers Make Money
Market makers are compensated for the risk of holding assets, as the value of a security might decline after purchase and before sale. They charge a spread on each security they trade. For example, if an investor sees a bid price of $100 and an ask price of $100.05, the market maker buys the stock for $100 and sells it for $100.05, earning a $0.05 profit per share. High-volume trading allows small spreads to accumulate into significant daily profits.
Market makers must operate under exchange bylaws, approved by regulators like the SEC, with their rights and responsibilities varying by exchange and financial instrument.
Market Makers vs. Designated Market Makers (DMMs)
While many exchanges use a system of competing market makers, some, like the NYSE, use Designated Market Makers (DMMs). DMMs, formerly known as specialists, have exclusive control over the order flow for specific securities. They post bids and asks for the entire market, ensure accurate reporting, maintain the best price, execute all marketable trades, and manage order on the trading floor. They also set the opening price each morning based on supply and demand.
Market Makers by Exchange
NYSE and Nasdaq: Major U.S. exchanges where market makers include Credit Suisse, Deutsche Bank, Goldman Sachs, and others.
Frankfurt Stock Exchange: Germany's largest exchange, where market makers are known as designated sponsors, including Berenberg, JPMorgan, and Morgan Stanley.
London Stock Exchange (LSE): Part of the London Stock Exchange Group, with key market makers like BNP Paribas and Mediobanca.
Tokyo Stock Exchange Group: A combination of the Tokyo and Osaka exchanges, with market makers such as ABN AMRO Clearing and Nomura Securities.
Toronto Stock Exchange (TSX): Canada's leading exchange, with market makers like BMO Nesbitt Burns and Scotia Capital.
Example of a Market Maker in Action
Consider a market maker in XYZ stock with a quote of $10.00 (bid) - $10.05 (ask) for 100x500 shares. They will buy 100 shares at $10.00 and sell 500 shares at $10.05. Other market participants can then buy from the market maker at $10.05 or sell to them at $10.00.
Summary
Market makers play a crucial role in the securities market by providing liquidity and facilitating trades. They earn profits through the bid-ask spread and operate under strict regulations to ensure market stability and fairness.