What Is it to Make a Market?
Making a market is an action whereby a dealer or market maker stands by, ready to make a two-sided quote. This quote indicates they are willing and able to either buy or sell a particular security at the quoted bid and ask price.
Being able to make a market in this way allows for liquid and efficient markets. Markets can be made on anything that is exchanged, from stocks and other securities to currency exchange rates, interest rates, commodities, and so on.
Key Takeaways
- To make a market means to be willing to trade a security against a counterparty by producing a firm bid to buy and offer to sell.
- Market makers display buy and sell quotes for a guaranteed number of shares, take orders from buyers, and then sell shares from their inventory to complete the order.
- Those who make markets hold on to large inventories of securities at all times so that they can always satisfy investor demand, quickly, and at competitive prices—regardless if it is a buy or sell order.
- Being a market maker requires a higher risk tolerance than a conventional brokerage because of needing to hold large amounts of a security at any given time.
Understanding Make a Market
To make a market is to display a bid (where you are willing to buy) and an ask or offer (where you are willing to sell). If you were a grocer, for instance, and were asked to make a market on the price of an apple, you might indicate $0.10 - $0.50 ("ten cents bid at fifty cents"). This means you'd be willing to buy an apple for a dime, and sell an apple for half a dollar. The key point is that when asked to make a market, you do not necessarily know in advance if the requester is an interested buyer or seller.
Market makers and dealers are the ones that makemarkets on securities exchanges. Market makers aremarket participants or member firmsof an exchange that buyand sellsecurities against other counterparties at prices displayed in an exchange’s trading system for their own accounts (calledprincipal trades) and for customer accounts (called agency trades). Market makers can enter and adjust quotes to buy or sell, enter, and execute orders, and clear those orders.
Market makers exist under rules created by stock exchanges approved by a securities regulator. In the U.S., theSecurities and Exchange Commission (SEC) is the main regulator of the exchanges. Market maker rights and responsibilities vary by exchange and themarket within an exchange, such asequities or options.
Market makers make money via the spread on each security they cover—namely, the difference between the bid and ask price; they also typically charge investors fees to use their services.
How a Market MakerWorks
In order to make a market, a brokerage firm must be willing to hold a disproportionately large amount of a given security soit can satisfy a highvolumeofmarketorders in a matter of seconds at competitive prices.In contrast to a conventional brokerage, being a market makerrequires a higher risk tolerancebecause of the high amounts of a given security that a market maker must hold.
Marketmakers promote market efficiency by keeping marketsliquid. To ensure impartiality for their clients, brokerage houses that function asmarket makersare legally required to separate their market-making activities from their brokeragesalesoperations.
Market makers smooth out the process of trading by making it easier for investors and traders to buy and sell securities; if there were no market makers, it could mean not enough transactions and not enough trading going on to keep the process fluid.
Market Makers Facilitate Liquidity
If investors are selling,market makersare obligated tokeep buying, and vice versa. They are supposed to take the opposite side of whatever trades are being conducted at any given point in time. As such,marketmakerssatisfy the market demand for securities and facilitate their circulation. TheNasdaq, for example, relies onmarket makerswithin its network to ensure efficient trading.
Market makersprofitthrough themarket-maker spread, not from whether a security goes up or down. They are supposed to buy or sell securities according to what kind of trades are being placed, not according to whether they think priceswillgo up or down.
