Market Maker Essay

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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.

Bibliography: 

  1. Investopedia, www.investopedia.com (cited March 2009);
  2. Securities and Exchange Commision, www.sec.gov (cited March 2009)

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