Market Maker

Definition

A market maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security to facilitate trading in that security. They act as both a buyer and seller of a given financial instrument to ensure liquidity. Each market maker displays buy and sell quotations for a guaranteed number of shares and must always be prepared to buy and sell at its displayed prices.

Phonetic

The phonetics of the keyword “Market Maker” is: /ˈmɑːrkɪt ˈmeɪkər/

Key Takeaways

1. Liquidity Provision: Market makers play a critical role in providing liquidity to financial markets. They are always ready to buy or sell, ensuring trade continuity, easing the buying/selling process, and contributing to market efficiency.
2. Price Stability: By continuously quoting bid and ask prices and standing ready to buy or sell, market makers help bring price stability to the markets. They narrow the spread between bid and ask prices, which can reduce price volatility.
3. Profit From the Spread: Market makers profit from the difference between the bid and the ask price, known as the spread. This allows them to compensate for the risk taken in buying assets and holding them until a buyer is found.

Importance

A market maker is an essential entity in finance because it adds liquidity to the financial markets, ensuring securities can be bought or sold at any time. Market makers achieve this by continuously offering to buy and sell securities at the bid and ask price, respectively, making it feasible for investors to transact whenever they wish. They help reduce transaction costs, maintain fair and orderly markets and provide a smoother trading experience. In addition, market makers also absorb some risk by holding a particular position in a security for a certain duration, which supports the efficient functioning of financial markets. Therefore, their role as intermediaries is crucial in enabling immediate trade and sustaining market vitality.

Explanation

Market makers serve a crucial role in ensuring the smooth functioning of the financial markets. Their main purpose is to increase market liquidity, hence facilitating seamless trading for investors. By always being ready to buy or sell securities at publicly quoted prices, they essentially “make the market” and ensure that traders can execute trades whenever they wish. Without market makers, it could be challenging to find a buyer or seller at desired price points, which could result in sporadic trading and extreme price volatility. Furthermore, market makers aid in reducing the spread (difference between the bid and ask prices), thereby reducing transaction costs for investors. They are also pivotal in implementing monetary policies. Central banks, for instance, use market makers to buy or sell government bonds to regulate the supply of money in the economy. To sum it up, market makers drive market efficiency and stability by facilitating regular trading, enhancing liquidity, and minimizing transaction costs for investors.

Examples

1. Knight Capital Group: Knight Capital Group, an American global financial services firm, was one of the largest market makers on the New York Stock Exchange (NYSE) and the Nasdaq Stock Market. They used algorithms to create liquidity in the market by placing simultaneous buy and sell orders for stocks. 2. Citadel Securities: Citadel Securities is a leading global market maker across a broad array of fixed income and equity products. They help meet the liquidity needs of asset managers, banks, broker-dealers, hedge funds, government agencies, and public pension programs by providing continuous bid and offer quotations for over 3,000 U.S. stocks on various venues, significantly contributing to market liquidity. 3. Virtu Financial: Virtu Financial is a highly prominent technology-enabled market maker and liquidity provider to the global financial markets. They make markets by providing competitive bid and ask prices in over 19,000 securities worldwide. They have often been involved in situations where high-frequency trading and algorithms have been used to take advantage of minuscule price discrepancies in the market.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Bid-Ask Spread
• Liquidity
• Inventory Risk
• Trade Volume
• Direct Dealing

Sources for More Information

• Investopedia
• Wikipedia
• The Balance
• The Motley Fool