A firm or an individual that engages in two-sided markets of a given security
Written byCFI Team
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What is a Market Maker?
Market maker refers to a firm or an individual that engages in two-sided markets of a given security. It means that it provides bids and asks in tandem with the market size of each security. A market maker seeks to profit off of the difference in the bid-ask spread and provides liquidity to financial markets.
Summary
- Market maker refers to a company or an individual that engages in two-sided markets of a given security.
- A market maker seeks to profit off of the difference in the bid-ask spread.
- The purpose of a market maker in a financial market is to keep up the functionality of the market by infusing liquidity.
Market Maker – Example
Consider a situation where a market maker in stock alpha can provide a quote for $5-$5.50, 100×200. It means that they want to buy 100 shares for the price of $5 while simultaneously offering to sell 200 shares of the same security for the price of $5.50. The offer to buy is known as the bid, while the latter offer to sell is the ask.
Other participants in the market have the option of lifting the offer from the market maker at their ask price, i.e., $5.50. It means that they can buy from the market maker at the given price. They can also hit the bid or sell to them for their bid price, which is $5.
The difference of $0.50 in the ask and bid prices of stock alpha seems like a small spread. However, small spreads, as such, can add up to large profits on a daily basis, owing to large volumes of trade.
What Entities Act as Market Makers?
A market maker can either be a member firm of a securities exchange or be an individual market participant. Thus, they can do both – execute trades on behalf of other investors and make trades for themselves.
When they participate in the market for their own account, it is known as a principal trade. When a principal trade is made, it is done at the prices that are displayed at the exchange’s trading system. The bid-ask spread is the total profit made by the maker. A bid-ask spread is the difference between the amounts of the ask price and bid price, respectively.
For instance, in the above example, the bid-ask spread is the difference between $5.50 and $5. The total profit made by the market maker is $50 ($5.5 * 200 – $5 * 100 – $5.5*100).
The most common example of a market maker is a brokerage firm that provides purchase and sale-related solutions for real estate investors. It plays a huge part in maintaining liquidity in the real estate market.
Usually, a market maker will find that there is a drop in the value of a stock before it is sold to a buyer but after it’s been purchased from the seller. As such, market makers are compensated for the risk they undertake while holding the securities.
Why are Market Makers Important?
The purpose of market makers in a financial market is to keep up the functionality of the market by infusing liquidity. They do so by ensuring that the volume of trades is large enough such that trades can be executed in a seamless fashion.
In the absence of market makers, an investor who wants to sell their securities will not be able to unwind their positions. It is because the market doesn’t always have readily available buyers.
If a bondholder wants to sell the security, the market maker will purchase it from them. Similarly, if an investor wants to purchase a given stock, market makers will ensure that shares of that company are available for sale. Thus, they act as wholesalers in financial markets.
The prices set by market makers are a reflection of demand and supply. Stockbrokers can also perform the function of market makers at times. It, however, represents a conflict of interest because brokers may be incentivized to recommend securities that make the market to their clients.
Learn More
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
