Britannica Money (2024)

Have you ever noticed how quick and efficient it is to buy and sell most commonly traded stocks? You execute a market order, and bam! It’s filled almost immediately. Also, the spread between the prevailing bid and offer prices (the bid-ask spread) is typically tight—often just a penny or two wide. It’s as if there’s always a crowd of market participants on the other side of your keystroke, ready to take your order within milliseconds.

For a market to be considered a market, there must be buyers and sellers present to engage in trade. However, not all markets have a good balance between buyers and sellers. Not all markets are efficient or liquid.

This is where market makers come in. They provide liquidity and efficiency by standing ready to buy and sell assets at any time.

What is a market maker?

A market maker is an individual or firm that continually provides bid-ask spreads in a market. They’re constantly buying and selling stocks, options, futures, and other securities, keeping those markets liquid.

In fact, a market maker is often called a “liquidity provider,” as their job is to facilitate the flow of the market.

Market makers may not be the most transparent participants in the trade life cycle—they operate behind the scenes, using high-frequency algorithms and complex arbitrage strategies. They have a clear profit motive, but the result is (mostly) liquid and smooth-running markets.

How significant are market makers’ impact on the markets?

The best way to understand this is to compare a liquid market with an illiquid market.

Suppose you want some cash, so you decide to sell a few hundred shares of a tech stock you’ve been sitting on. Without market makers, you’d need to wait (and hope) for someone else to place a buy order, at your selling price, in your exact quantity, ASAP, so you can get the money in your bank account.

Market makers monitor the entire market, including stocks, options, and futures on stock indexes, many of which are listed on one or more of several exchange and execution venues. As a result, the difference between the bid and ask is usually a few pennies at most (often less).

That’s a tight spread. Plus, the volume of shares on both sides of the market tends to be high. Now, that’s an efficient market.

How do market makers make money?

Market makers profit by buying on the bid and selling on the ask. So if a market maker buys at a bid of, say, $10 and sells at the asking price of $10.01, the market maker pockets a one-cent profit.

Market makers don’t make money on every trade. Sometimes the market gets overloaded with lots of buy orders or lots of sell orders. But because orders must cross the prevailing spread in order to make a trade, the market maker makes a theoretical profit on every trade.

According to data from securities trade association SIFMA, the average daily volume among U.S. stocks is 11.3 billion shares (as of July 2023). When you consider Bernoulli’s law of large numbers, those theoretical pennies and fractions of pennies become actualized over time, and they really add up.

How’s this different from a typical short-term trade?

Here’s a key point to remember: Market makers don’t have an opinion on the direction of the market. That’s the difference between a speculator or fund manager versus a market maker. Market makers are direction-neutral. In other words, they’re simply looking to profit from the bid-ask spread.

Despite their market-neutral position, market makers still face directional risk, especially when prices are volatile. To avoid volatility risk, market makers often hedge their positions with correlated instruments (such as options or futures).

Isn’t most market-making computer-driven?

Although the exact figure may vary depending on whom you ask, the percentage of algorithmic (computer-backed) high-frequency trading (HFT) in the U.S. sits somewhere between 50% to 75%.

Although this introduces an unprecedented degree of speed and efficiency into market making, the technology has also spawned a number of controversial practices that have created an air of suspicion surrounding any institution or individual using HFT.

Two well-known market manipulation practices include spoofing and front-running:

• Spoofing means placing a large order to buy or sell a security with the intent of canceling it before it’s executed. This can artificially move prices by creating an illusion of high demand or supply.
• Front-running means buying or selling a security knowing that a large order is about to be executed. This gives the front-runner an unfair advantage over other market participants.

But aren’t market makers regulated?

Yes. The stock and equity option markets are regulated by the Securities and Exchange Commission (SEC). The Financial Industry Regulatory Authority (FINRA) is a government-authorized, not-for-profit organization that oversees U.S. broker-dealers. (For more on financial market regulators, here’s an overview.)

But the important thing stock investors want to know is how market makers are regulated when it comes to quoting the bid-ask spread. After all, that’s how they make money.

Enter the National Best Bid and Offer (NBBO). The NBBO takes the highest bid price and the lowest ask price from all of the exchanges that list a stock for trading. Market makers are required by SEC regulations to quote the NBBO or better.

Here’s a simple example of how that might look:

All five exchanges have a wide bid-ask spread, but the NBBO combines the bid from Exchange 1 with the ask from Exchange 5. As liquidity providers, market makers can quote or improve these prices.

What do you mean by “improve” these prices?

A market maker may quote a spread that’s tighter than the NBBO, say, a bid of 50.27 and an ask of 50.28. In that case, the market maker’s profit may be reduced, but it represents price improvement for the investor.

Why would market makers competitively improve prices?

There are plenty of market makers in the financial industry competing against one another. In this line of business, speed and frequency of trades (i.e., buying on the bid and selling on the ask) is the profit-generation engine. A one-cent profit gained is an opportunity taken away from another market maker who’s hoping for a two-cent profit.

The presence of competition (among traders, investors, and especially market makers) is what generates liquidity and drives market efficiency.

The bottom line

Market makers play an essential role in keeping financial markets fluid and efficient. They do this by standing ready to buy and sell assets at any time. They’re regulated entities, and they operate in a highly competitive market. Overall, and ideally, these factors combine to give investors a smoothly running market offering competitive prices.

Big market makers such as Citadel Securities, Wolverine Capital Partners, and Susquehanna International Group are wide-scale, capital-intensive, and highly profitable. At every moment during the trading day, these and other market makers are ready to take the other side of your order for a razor-thin theoretical profit margin.

Specific companies and funds are mentioned in this article for educational purposes only and not as an endorsem*nt.

References

• [PDF] Staff Report on Algorithmic Trading in U.S. Capital Markets | sec.gov
• Price Improvement | schwab.com