A market maker is a bank or brokerage company that continuously publicly displays (quotes) ask and bid prices (for a guaranteed number of shares) at which they will sell or buy during the trading days. This financial operator ensures the liquidity and efficiency of the financial markets (making easier the trade of blocks of shares) and, therefore, reduces the transaction costs.
There are two ways of treating financial orders: matching (fully or partially) the orders recorded in a book orders or having a market maker that accepts directly the orders given by the market participants. On the one hand, a book orders matches the bid prices with the ask prices. If the highest bid price is equal (or above) the lowest ask price and there are enough shares available, the trade is immediate. However, if the highest bid price is below the lowest ask price, the order is recorded and displayed to later traders. On the other hand, a market maker buys or sells the security, and adjusts the price after according to their beliefs. For example, when a customer places an order (with a broker) to buy (sell) shares of a stock, the market maker will actually sell (purchase) the stock (even if he does not have a buyer [seller]), “making a market” for the specific stock.
It is possible to run a market using both a market maker and a book orders. Indeed, a market maker will work better in a small market (few offers) and a book order will work better in a large market (plenty of offers). The rule is that the market maker’s orders must have the priority. Using a market maker enlarges the set of potential trades. This observation is even more visible in thin markets where the book orders is almost empty. The inclusion of the book orders method simplifies the adjustment of the market to increasing volume. Then the book orders procedure intervenes more significantly when the market gets thicker (lowering volatility).
The majority of the stock exchanges operate on an order-driven basis (matching the buyer’s bid and the seller’s offer) instead of using market makers. However, the integration of market makers is growing rapidly and presents some advantages for investors. For instance, the NASDAQ is an operation of market makers (more than 500 member firms that act as NASDAQ market makers). Generally, each market maker competes with the other market makers (who are dealing on the same security) to obtain the deal with the client. In this way, this ensures the market to be more efficient and competitive. Note that many over-the-counter (OTC) stocks have more than one market maker. There is generally a clear separation between the market-making side and the brokerage side to avoid brokers’ recommending specific securities for which the firm makes a market.
The market makers take no commission on the sale but instead make their money on the bid/ask spreads or on the offsetting of their positions. The bid/ask spread is the difference between ask and bid prices. This spread is rarely equal to zero, and the market maker will only make a trade when there is sufficient profit on the sale, i.e., a sufficient spread. On heavily traded stocks, this compensation for the risk they take (holding a certain number of shares of a particular security) can represent a handsome profit even if the bid/ask spread is very small. Note that a market maker makes a profit on every sale, whether the market goes up or down. Obviously, the opportunity to become a market maker is very rare and controlled.
Market makers support different principal kinds of risk:
- Liquidity risk: A market maker provides liquidity to his working market; however, he is not certain to find the necessary liquidity to reverse the positions that he has inherited. In this way, a market maker needs to find a trade-off between highly liquid markets (with low bid/ask spreads and therefore low profits) and illiquid markets (with high bid/ask spreads and therefore high potential profits).
- Operational risk: A market maker is also exposed to potential operational risk arising from business functions and the practical implementation of his management strategy. This concept integrates notably information, fraud, physical, and environmental risks.
- Information asymmetry: The market maker should pay the correct prices for his positions, but he will never have all the information because the markets are not perfectly efficient (the information is not homogeneous and not perfect).
There are some differences between a market maker and a market specialist (NYSE). However, they serve the exact same purpose.
- Investopedia, www.investopedia.com (cited March 2009);
- Securities and Exchange Commision, www.sec.gov (cited March 2009)
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