What Is a Market Maker and What Do They Do? (2024)

Are you a market maker? Whether you want to buy a car, groceries, stocks, or Bullish Bears swag, you need two parties—a seller of the goods and a buyer of the goods, which in this case is you. You also need a sale location: the grocery store for groceries, a car dealership for cars, and the website for Bullish Bears swag.

To add further complexity, the buyer naturally wants to pay the lowest price, and the seller wants the best price for their product. Predictably, we have a spread in what both want for payment.

What Is a Market Maker?

A market maker is a company or person who controls stocks’ buying and selling aspects. The goal is to profit from both the bid and the ask spread. You need two parties to make that happen. Plus, the market maker.

Think of it like this: you head into a car dealership willing to pay only $100,000, but you see a beautiful car listed at $240,000. You don’t want to pay the extra $140,000, but it’s an exotic car with only a few models made.

Predictably, the spread will stay large if there isn’t a lot of inventory available, with little wiggle room to barter on price, which means that the dealer will profit handsomely in the deal.

However, if 20 other dealerships in the city sell the same car, you can narrow that spread down to a more reasonable price. In this case, the spread is less with lots of inventory, and the dealer’s profit is lower.

And this is no different in the world of trading. Whether it’s stocks, options, or exchange-traded funds (ETFs), they all need a market of buyers and sellers to move on the exchanges. And we also need a large supply of inventory, so you’re not stuck with huge prices.

But where does this liquid market come from?Two words: Market Makers

Making a market” refers to the willingness to buy and sell the securities of a set of companiesto broker-dealer firms of that specific exchange.

For starters, each market maker displays buy and sell quotations for a guaranteed number of shares. Once the market maker gets an order from a buyer, they immediately sell off their position of shares from their inventory, completing the order.

In short, market-making makes it smoother and easier for us to buy and sell securities. Without it, buying and selling stocks would be a long and painful process.

Market makers, also known as high-volume traders, literally “make a market” for securities. A market maker (MM) can be a firm or an individual who actively quotes two-sided markets in certain securities. They are the folks behind the high frequency trading softwareyou all hear about in chat rooms and message boards.

Market makers are often large brokerage firms that provide trading servicesfor investors and traders alike. Not only do they profit dearly from their services, but they keep liquidity in thefinancialmarkets.

Even though a market maker can also be an individual trader, it’s highly unlikely. For the most part, the size of securities needed to facilitate the volume of purchases and sales exceeds trader Bob’s reach. Because of this, most market makers work on behalf of large institutions.

Before diving in, you must understand the difference between a Nasdaq Market Maker and an NYSESpecialist. For starters, an NYSE Specialist is a type of market maker who works on the NYSE floor and specializes in trading specific stocks.

Alternatively, the Nasdaq Marker Makers are large investment companies that buy and sell securities through an electronic network. They provide a competitive trading environment and efficient, low-cost execution of orders.

Multiple market participants utilize NASDAQ’s trading services, including market makers, order-entry firms, and electronic communications networks (ECNs).

To that end, market makers provide bids and offers (known as asks) and the market size. A bid-ask spread is a difference you can buy the units for at any given time or what you can sell them for on the market then.

Secondly, it represents the cost to the market maker if they were to buy or sell the entire underlying basket to compensate them for the risk of making that market. Let’s clarify: Market makers profit on the bid-ask spread and benefit the market by adding liquidity.

Let’s say we have a market maker instockABC who provides a quote of $10.00-$10.05, 100(buy) x 500(sell). This means that they will bid (will buy) 100 shares for $10.00 while also offering (will sell) 500 shares at $10.05.

The other trader may buy (lift the offer) from the market maker at $10.05 or sell to them (at the bid) at $10.00. As a result, market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.

In case you didn’t know already,market makers produce liquidity. Liquidity is how easily you can get into and out of a stock position.

A stock is liquid if you can rapidly sell the shares with little impact on the stock’s price. It is essential because it helps traders get in and out of stocks more cheaply.

Now that we understand liquidity, let’s talk about market makers in theETF field. ETFs are unlike stocks in that a finite number of shares are available for sale on the market.

With an ETF, it’s an open structure. To clarify, an ETF provider can issue new shares or redeem shares of that ETF based on thesupply and demandin the market.

That said, the ETF ecosystem works and how liquidity is provided to the market. There are three levels of liquidity for an ETF. First is the natural level or the number of shares traded on the exchange.

Or the number of units sold by A and bought by investor B. Hence, the more units traded, the higher the liquidity.

The second level of liquidity is where the market-making activity comes into play. The market makers are the large institutions, typically the big banks.

Now, market makers are responsible for creating liquidity in the ETF market and posting bid/ask quotes (the number of shares available for sale or purchase) at a specific price.

Furthermore, they’re responsible for keeping the ETF price in line with its net asset value.Now, the third important layer of liquidity is the EFT provider. If there is a large buy order, the ETF provider delivers a creation unit of that ETF.

Typically, 50,000 shares of the ETF get delivered to the market maker, who then buys the ETF’s underlying securities. They then offer those ETF units for sale after a bid and ask for a quote for that ETF.

That may occur, for example, if you are a pension fund and buying ten million of a bond ETF. In reality, you will not buy that from other investors in the market and maybe not even from the market maker directly. The ETF providers will have to go out and create those new units and add them to the market.

The average retail investor trading 5-6k of an ETF doesn’t need the market maker and ETF provider to create new ETF units.

Typically, you’ll see this happening only in a considerable buy and sell order that exceeds the units’ current quantity.

• A market maker can be an individual market participant or a member firm of an exchange. They buy and sell securities for their account and display prices in their exchange’s trading system. Overall, their primary goal is to profit from the bid-ask spread.
• We often see brokerage houses as the most common type of market maker. Firms like this provide purchase and sale solutions for investors to keep financial markets liquid.
• Market makers get paid for the risk of holding securities because their value may decline when they buy it from a seller and sell it to a buyer.

At the same time, market makers must continuously commit to quoting bids and asking prices for securities.

Furthermore, they must commit to the volume they’re willing to trade and how long they will quote at the Best Bid and Best Offer (BBO) prices.

Regardless of market conditions, market makers must always stick to these parameters. Market makers must remain disciplined to continue facilitating smooth transactions even when markets become erratic or volatile.

Market makers sometimes are the bag holders. They’ve bought assets from a seller and risk seeing the value decline before they get a chance to sell it to a buyer.

Because of this, they get compensated for the risk of holding assets in the form of the bid-ask spread.

Remember when I talked about this above? Well, let’s say I decided to buy FB from my broker. On the screen, I see a bid price of $100 (what the broker paid for the stock) and an asking price of $100.05.

I buy it for $100.05, and the market maker keeps the $0.05. Now, this doesn’t seem like a large commission, but through high-volume trading, these small spreads add up fast; 6 figures fast, to be exact.

At this point, it’s safe to say the wheels of the money-making machine are churning in your head. I am starting to wonder how to become a maker of markets.

Keep reading to find out how.

A prospective market-making firm must already be or apply to be a NASDAQ member. Simultaneously, firms are permitted to be in a pending status when starting their connection process to the NASDAQ.

For information about membership requirements, please visit theirmembership page.If you are a NASDAQ member and don’t yet have connectivity to the NASDAQ systems, you must contact NASDAQ Subscriber Services at 212.231.5180.

You’ll need to pick the right market participant identifier (MPID) and establish connectivity through one of the NASDAQ protocols.

However, all NASDAQ members who already have access to NASDAQ need to follow the steps outlined below:

1. Complete the Market Maker Registration Form (PDF)
2. Have your clearing agency call the National Securities Clearing Corporation (NSCC) to arrange a clearing.
3. Contact the local FINRA District Office to express an interest in becoming a NASDAQ market maker.
4. Compile all information and send it to the local FINRA District Office for review to see if you are qualified to be a NASDAQ market maker.)
5. The FINRA District Office will forward an approval form to NASDAQ’s Subscriber Services department. (If your firm is not a FINRA member, the approval will be made by The NASDAQ Stock Market LLC.)
6. A NASDAQ Subscriber Services representative will notify you if you are permitted to make markets and will activate all your services.

• Enter, retrieve, monitor, and adjust quotations in response to changing market conditions.
• Enter and execute orders in all of the NASDAQ’s systems.
• Utilize automated services to compare and clear NASDAQ
• Register the number of securities approved by the firm’s local FINRA District Office. In case you didn’t know, FINRA provides regulatory services for all NASDAQ members on behalf of The NASDAQ Stock Market LLC.

Depending on the market makers’ jurisdiction, they must operate under a given exchange’s bylaws. Each exchange is approved by a country’s securities regulator, such as the Securities and Exchange Commission in the U.S.

Another key point is that rights and responsibilities vary by the exchange and the type of security you’re trading.

In some cases, a market maker is also a broker. Unfortunately, this can incentivize a broker to recommend securities for which the firm also makes a market.

As a trader, do your due diligence; ensure a clear separation between your broker and the market maker.