Market maker
Encyclopedia
A market maker is a company
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...

, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

 held in inventory, hoping to make a profit on the bid-offer spread
Bid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...

, or turn
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...

.
From a market microstructure
Market microstructure
Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructure of financial markets due to the availability of...

 theory standpoint, market makers are net sellers of an option to be adversely selected
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...

 at a premium proportional to the trading range at which they are willing to provide liquidity.

In currency exchange

Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets. In foreign exchange (or FX) trading, where most deals are conducted over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....

 and are, therefore, completely virtual, the market maker sells to and buys from its clients and is compensated by means of price differentials for the service of providing liquidity, reducing transaction costs and facilitating trade. Recent developments in the over-the-counter FX market have permitted even buy-side (non bank participants) virtually to act as market-makers through the advent of high speed/frequency software engines that submit bids and offers outside prices available on other networks or ECN (electronic communication network
Electronic communication network
An electronic communication network is the term used in financial circles for a type of computer system that facilitates trading of financial products outside of stock exchanges. The primary products that are traded on ECNs are stocks and currencies. The first ECN, Instinet, was created in 1969...

) where FX is traded.

In stock exchange

Most stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...

s operate on a "matched bargain" or "order driven" basis. In such a system there are no designated or official market makers, but market makers nevertheless exist. When a buyer's bid price meets a seller's offer price or vice versa, the stock exchange's matching system decides that a deal has been executed.

New York

In the United States, the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...

 (NYSE) and American Stock Exchange
American Stock Exchange
NYSE Amex Equities, formerly known as the American Stock Exchange is an American stock exchange situated in New York. AMEX was a mutual organization, owned by its members. Until 1953, it was known as the New York Curb Exchange. On January 17, 2008, NYSE Euronext announced it would acquire the...

 (AMEX), among others, have Designated Market Makers, formerly known as "specialists", who act as the official market maker for a given security. The market makers provide a required amount of liquidity to the security's market, and take the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders. In return, the specialist is granted various informational and trade execution
Best Execution
Best execution refers to the obligation of an investment services firm executing orders on behalf of customers to ensure that the prices those orders receive reflect the optimal mix of price improvement, speed and likelihood of execution...

 advantages.

Other U.S. exchanges, most prominently the NASDAQ
NASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...

 Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability to naked short
Naked short selling
Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame,...

 a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting. Recent changes to the rules have explicitly banned naked shorting by options market makers.

There are over two thousand market makers in the USA and over a hundred in Canada.

London

On the London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...

 (LSE) there are official market makers for many securities (but not for shares in the largest and most heavily traded companies, which instead use an automated system called TradElect). Some of the LSE's member firms take on the obligation of always making a two-way price in each of the stocks in which they make markets. Their prices are the ones displayed on the Stock Exchange Automated Quotation
SEAQ
The Stock Exchange Automated Quotation system is a system for trading mid-cap London Stock Exchange stocks. Stocks need to have at least two market-makers to be eligible for trading via SEAQ....

 (SEAQ) system and it is they who generally deal with brokers
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...

 buying or selling stock on behalf of clients.

Proponents of the official market making system claim market makers add to the liquidity and depth of the market by taking a short or long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...

 position for a time, thus assuming some risk in return for the chance of a small profit. On the LSE one can always buy and sell stock: each stock always has at least two market makers and they are obliged to deal.

In contrast, on smaller, order-driven markets such as the JSE Securities Exchange it can be difficult to determine the buying and selling prices of even a small block of stocks that lack a clear and immediate market value because there are often no buyers or sellers on the order board.

Unofficial market makers are free to operate on order driven markets or, indeed, on the LSE. They do not have the obligation to always be making a two-way price but they do not have the advantage that everyone must deal with them either.

Examples of UK Market makers since Big Bang Day are Peel Hunt LLP, Winterflood Securities, Liberum Capital, Shore Capital, Fairfax IS and Altium Securities.

Prior to the Big Bang, jobbers
Stockjobber
Stockjobbers were institutions that acted as market makers in the London Stock Exchange. Prior to "Big Bang" in 1986, every stock traded on the Exchange passed through a jobber's book, where they acted as intermediaries between stockbrokers, who were in turn not permitted to be market makers...

 had exclusive rights of market making on the LSE.

How a market maker makes money

A market maker aims to make money by buying stock at a lower price than the price at which they sell it, or selling the stock at a higher price than they buy it back. Ordinarily, they can make money in both rising or falling markets, by taking advantage of the difference between "bid" and "offer" prices.

Stock market makers also receive liquidity rebates from electronic communication networks (ECN) for each share that is sold to or purchased from each posted bid or offer. Conversely, a trader who takes liquidity from a bid or offer posted on an ECN is charged a fee for removing that liquidity.

See also

  • Sales and trading
    Sales and trading
    Sales and trading is one of the key functions of an investment bank. The term refers to the various activities relating to the buying and selling of securities or other financial instruments...

  • Day trading
    Day trading
    Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...

  • List of finance topics
  • Divide and choose
    Divide and choose
    In problems of fair division, divide and choose is a two-party proportional envy-free allocation protocol. The protocol also works for dividing an undesirable, as in chore division....

    , analogous to a two-way price
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