Investing > What’s a Market Maker?

What’s a Market Maker?

Market makers are an important part of the markets that maintain efficiency and ease of doing business - but most investors don’t actually know how they work.

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Updated April 22, 2022

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How does the stock market work?

Well, of course, this is a guide, so we’re not asking for emails with answers – but think about it. Stocks are listed on exchanges, and investors need a broker to buy them, so the brokerage buys the shares from the exchange with the money in the account, right?

Well…no, that’s actually wrong. Stock exchanges don’t actually own or hold stocks – they merely facilitate trading. There is an intermediary in this part of the process – and they’re called market makers. 🏗

So, what do market makers do? In short, they ensure that brokerage firms have reliable, predictable access to assets. This effect goes downstream as well – as a result, regular investors also get the benefits of simple, efficient, and quick transactions. But market makers don’t do this out of the goodness of their hearts – everyone involved in a stock market subsidizes them, in a way.

Market makers are a fundamental element of financial markets, yet they’re much less known to the general public than exchanges or stock brokerages. But even a layman’s understanding won’t be sufficient here – market makers are important. 🎯

Market makers have a great influence on various important factors such as market depth, trading volume, liquidity and even bid/ask spreads and commissions. All of these elements are crucial for making profitable decisions – and understanding market makers means also having a better understanding of those elements.

Although it might seem like an arcane and distant topic at first, we’ll do our best to illustrate, in plain language, how market makers work, how they make money, and how they affect regular, everyday retail investors.

What you’ll learn
  • What is a Market Maker?
  • Understanding Market Makers
  • Market Maker - Example
  • How Do Market Makers Earn a Profit
  • Is There Any Corruption with Market Makers?
  • Crypto Market Making
  • Conclusion
  • Get Started with a Stock Broker

What is a Market Maker? 📚

Market makers are an important part of the overall structure of the stock market. The purpose of market makers is to maintain a level of liquidity, in return for which they charge a bid/ask spread.

A representation of how market makers operate during a trade, profiting from bid/ask spreads.
Market makers maintain liquidity in the market, profiting from bid/ask spreads.

Sounds confusing? Don’t worry, we’ll break it down so that it is much easier to understand. When one thinks of the stock market,  one of the first things that spring to mind is how many millions of transactions are executed every day. On average, the NYSE sees between 2 and 6 billion transactions every day, while NASDAQ experiences 4.5 billion each day – and those are just two stock exchanges.

On the other hand, stock brokerages serve as an intermediary between an investor and the stock market – they don’t actually own the securities that they sell to investors, but they must strive to always have a reliable way of getting them to investors. In order to attract clients, the most reliable stock brokers offer commission-free trading and the dependability to execute a high volume of transactions.

That is where market makers come in – they buy and sell large blocks of stocks so that the market can function faster and more smoothly – and in return, they charge a price that is inherent to most forms of investing – a bid-ask spread.

Understanding Market Makers 👨‍🏫

To understand market makers, we will have to tackle a variety of topics – how market makers function, how they influence the markets, and how their functions contrast and overlap with that of stockbrokers.

How Do Market Makers Work? 👷‍♂️

Market makers work in tandem with exchanges. Exchanges like the NYSE and NASDAQ serve to provide a marketplace where buyers and sellers can meet. Along with that, exchanges have stringent listing requirements put in place to ensure that companies that appear on the exchange operate transparently, legally, and within regulatory frameworks and oversight.

But stock exchanges don’t actually *own* or *hold* any shares. Think of an exchange like a farmers’ market. In this scenario, the market maker would be the trucking company that ensures that there are fruits and vegetables on the stands. 

If we were to take this example a bit further, a stock brokerage would be someone you pay a little money to sell vegetables you own and buy others (with the prices predetermined), in order to profit.

But that’s enough talk about food. The meat and potatoes of the story is that market makers provide liquidity – the ease of doing business (buying and selling) and converting assets to cash. This benefits both institutional investors, funds like ETFs, as well as retail investors. 

In return for that benefit, anyone who wants to take care of a transaction has to pay a price. When a market maker buys a stock, it will sell it for a higher price – and when it sells a stock, it buys it at a lower price. 

This is called the spread or the bid/ask spread – and while it is usually narrow, it piles up quite quickly seeing as how market makers take care of innumerable transactions each day. Along with this, market makers are also allowed to make trades with their own accounts simply to make profits – this is known as a principal trade.

Visual depicting the two types of trades market makers handle
Market makers handle two different types of trades: agency trades and principal trades.

How Market Makers Influence the Market 🤔

Market makers are an indispensable element of every functioning financial market. Although they do charge spreads, the benefits they provide with regard to liquidity, trading volume, and ease of doing business are a net positive, and competition means that market makers are incentivized to be as affordable as possible.

However, market makers aren’t without their share of critics – with many investors feeling as if market makers engage in market manipulation by moving prices with large sell and purchase orders. The line gets particularly blurry with market makers that also function as brokerages – and therefore have an additional incentive to recommend certain securities over others.

However, the general consensus is that market makers (at least the reputable ones) are a straightforward, well-regulated method of ensuring liquidity. Sure, they do charge a premium in the form of spreads, but these are private companies – their motive is profit. They’ve just found themselves a good niche, and the entire market is better off for it.

Without market makers, there’s no telling how stock trading volumes and prices would change – to put it simply, the way that the stock market operates isn’t imaginable without market makers. ETFs and mutual funds wouldn’t be able to exist without them either; and market makers are a large driving force and big buyers when it comes to funds, helping to stabilize another section of the market.

Market Makers vs. Brokers ⚔

Market makers and brokers are part of the same overall pipeline and system – but they do differ in key aspects that should be understood. Understanding both the similarities and the differences between the two is an important step to take before moving on to another topic – why the overlap of the two is ill-regarded and best avoided.

To begin with, a brokerage is a person or more commonly a firm that is authorized to execute buy and sell orders on the behalf of the client. Brokers act as intermediaries between clients and market makers – and market makers act as intermediaries between brokerages and the wider market, much like a wholesaler.

Brokers coordinate buyers and sellers by matching buy and sell orders – market makers are there to make sure that trading volume and liquidity are sufficient by placing a lot of large orders. Market makers profit by charging the bid/ask spread – brokers profit by charging various fees and commissions.

Market MakersBrokers
Usually a firmUsually a firm, but can be an individual
Profit from bid/ask spreadsProfit from fees, commissions, and payment for order flow
Usually owned by large banks or financial institutions Independent companies

Brokers send orders to market makers for execution. In exchange for reliability and low spreads, market makers pay brokerages via payment for order flow (PFOF) – a payment that usually doesn’t exceed a fraction of a penny per share.

All of the costs that are associated with the services that market makers provide are passed on to retail investors, so they play a large part in determining the fee and commission structures of brokers as well. Whereas brokers are often independent companies, market makers are usually owned by large financial institutions or banks.

Market Makers vs. Specialists ⚖

Although the terms”market maker” and “specialist” are sometimes used interchangeably, this is an error. Although they fulfill similar roles, there are key differences between the two.

We’ll demonstrate using a real-life example, but that requires a bit of homework first. The two most important and famous exchanges in the United States are the New York Stock exchange (NYSE) and NASDAQ.

NASDAQ is an electronic network and the NYSE has a trading floor. NASDAQ uses market makers – the NYSE uses specialists. Okay, but what about the core differences? A specialist is usually one person on the NYSE trading floor, and market makers are usually large companies. In practice, it all boils down to this, however – specialists focus on certain securities and sometimes have a monopoly on the order flow of one or more securities. 

Market MakersSpecialists
Usually a companyAn individual
Is not specialized in specific securitiesSpecializes in certain securities
Focus solely on providing liquiditySet opening stock prices, accept orders
Operate as an electronic networkOperate on a trading floor

On top of that, specialists have some additional duties – setting the opening stock prices of the day in accordance with supply and demand, making sure that the best prices are maintained, accepting orders from brokerages, and many more.

In practical terms, these differences don’t mean much – they don’t affect the way retail investors experience the market, and depend only on the exchange in question.

Example of Market Maker 📝

To put things into perspective, let’s use a hypothetical example to better illustrate how market makers work. Some of the largest market makers in the U.S. stock market include Citadel, Deutsche Bank Securities Inc, and Credit Suisse Securities LLC.

Nvidia (NASDAQ: NVDA) experienced large price fluctuations in the first fourth months of 2022, including a well-publicized drop in stock price. As one of the leading companies in its industry, it might very well recover from that drop – so many investors are doing just that and opening large positions. For our example, we’ll use the stock price as of the time of writing – $215.

If an investor wanted to buy 100 shares in Nvidia, they would need two things – somewhere around $21,500, and someone willing to sell them 100 shares. That isn’t a small amount of money – and it isn’t a small stock order, either.

So, to help keep things running smoothly, this is where market makers such as Citadel and Deutsche bank come in. Market makers are always ready to purchase large blocks of shares at the current bid price and sell them at the asking price.

Let’s make things a little more concrete. Market makers operate by placing large orders, which usually look like this: $214.30-$215.70, 100×200. Confused? Don’t worry – it’s actually quite simple.

What is seen here is an order to buy 100 shares at $214.30, while simultaneously selling 200 shares at $215.70. The difference between the buy offer or the bid, and the sell offer or the ask is the bid/ask spread – and this is how market makers make money.

In our particular case, the market maker would stand to make a profit of $1,40 per share sold – and while that seems like scraps, keep in mind that Nvidia experiences an average daily trading volume of around 50 million stocks. That’s a potential profit of $70 million each day – only from one stock.

How Do Market Makers Earn a Profit 💰

Market makers hold assets, which comes with a certain degree of risk involved because before the assets are disposed of, the price of those assets can depreciate or appreciate in the meantime. In essence, market markers have to make up for any and all of those potential differences – and they do exactly that by charging a market maker’s spread.

A market maker’s spread is functionally identical to the bid/ask spread – but is applied as a surcharge, fee, or commission that clients are charged for. Because a lower bid/ask spread is appealing to clients, market makers are enticed to offer the lowest possible spreads in order to attract customers.

Still, one has to keep in mind that market makers handle a lot of transactions each day – even a $0.5 charge applied millions of times still ends up raking in a lot of money. So, apart from high-frequency and high-volume trading, can market makers earn a profit in any other way?

Well, that chiefly depends on the jurisdiction and exchange being discussed. A market maker has to comply with the regulatory framework of the country it is operating in (such as following SEC rules in the U.S.), as well as with the bylaws of the exchange it operates in. 

For example, in some jurisdictions, listed companies are allowed to pay market makers in exchange for making sure their shares are liquid and experience a stable trading volume. Along with this, market makers can make use of stock purchases and trading options to profit from capital appreciation. To cap it all off, some market makers also operate as brokerages – but we will discuss this later.

Is There Any Corruption with Market Makers in the U.S. Stock Market? 👮‍♂️

While there is no corruption with market makers in the U.S., because of strict regulations, there are still a couple of less-than-savory practices that are common and slightly exploitative. They don’t tend to cause huge losses to retail investors but are best avoided.

How to Avoid Manipulation from Market Makers ⚠

Market makers are obligated to honor their orders, but they can still use their influence to create favorable conditions for themselves. One of the easiest ways to do that is by posting large orders (with or without the intent to fill them).

If a market maker owns a position in a stock and posts an order to buy thousands of shares in that stock, that can create the impression of buying pressure and increased investor interest. This, in turn, can easily be interpreted as a sign that the stock’s price is going to rise.

In reality, there’s nothing happening – the market maker is simply looking to drum up interest in order to make their principal trades more profitable. While this method of doing business isn’t quite exactly illegal, it is still disapproved of by regulatory bodies.

Order types are complex but worth mastering. Market orders provide market makers with a convenient way to overcharge retail investors – so, how can one avoid this form of manipulation? Simple – make sure to use limit orders.

When an investor places a market order, they’re willing to pay a price similar to the current price for the stock. Because stock volumes are generally high, this allows market makers to make sure that orders are filled, but on the high-end of the price range.

A limit order sidesteps this – it includes a limit as to how much an investor is willing to pay at most and a time limit on how long the order is good for. This allows investors to make much more calculated decisions, without being at the mercy of fluctuating prices and widening spreads.

Market Maker / Brokerage Hybrids 🏢

A lot of brokerage firms operate as market makers – while this might seem appealing at first glance, as a sort of “one-stop-shop” that can make sure orders get reliably filled, investors ought to avoid these types of brokers.

Why is that? The answer lies in principal trades – market makers that function as brokerages have an incentive to promote securities that they are holding, in order to make their own trades more profitable.

Market makers might be a fundamental part of the structure of a financial market, but the roles of brokerage and market maker are best left separate, and investors should take the time out to make sure whether or not a broker works as a market maker before opening a brokerage account.

Is ComputerShare an Alternative to Market Makers? 👨‍💻

ComputerShare might be a familiar name to some of our readers – particularly if they have been paying attention to the recent discourse regarding hedge funds and short selling best exemplified by the cases of Gamestop (NYSE: GME) and AMC (NYSE: AMC).

Basically, ComputerShare allows investors to directly purchase stocks. This stands in contrast to the traditional route of going through a stock brokerage, where the brokerage itself holds the shares for the investor.

By purchasing stocks directly through a service like ComputerShare via a direct registration system, investors can prevent their shares from being loaned by brokerages for the purpose of short selling.While that might be a lofty goal and a good way to combat the controversial phenomenon of naked short selling, there is another, more important reason why investors went to ComputerShare in droves. In January of 2021, the buying and selling of “meme stocks” like GME and AMC were limited by the likes of Robinhood and TD Ameritrade.

This struck a sour note with many retail investors, who saw this step as a backlash against the anti-hedge-fund holding crowd and were understandably resentful for the missed opportunities. In order to purchase stocks and get in on the action, many flocked to ComputerShare, and others transferred their shares to this provider as a sign of protest.

Direct registration systems such as ComputerShare offer a way to sidestep such events, although investors should keep in mind that buying shares using this method is significantly more expensive and likely to incur fees.

Crypto Market Making 🪙

The cryptocurrency market is an exciting new frontier – it’s hard to miss all stories of both glorious rises and falls, as well as the unstoppable growth of the market. But the crypto market still has a ways to go and a ways to grow – there are still some issues that the market is struggling with.

The most important of these issues are liquidity and volatility, which are deeply tied to one another. Market makers help provide liquidity, thereby reducing volatility – so are there any crypto market makers?

Yes – in fact, crypto market making is an exciting and vibrant new development. Companies such as GSR Market, Kairon Labs, Openware, AlphaTheta, B2C2, and Altonomy, among many others, serve as cryptocurrency market makers.

It’s hard to overstate how important this is for the wider crypto market – market makers reduce slippage, dampen price swings, lead to narrower spreads, and help institutional investors gain easier access to the market.

Conclusion 🏁

That’s it for this guide – we hope enterprising investors around the globe will find it helpful. This topic is firmly tied to factors such as liquidity, stock volume, and trading fees – all of which are important when investing.

Market makers are an essential part of the global financial markets, and while those intricacies might not seem interesting (or even important) at first glance, they allow investors to attain a much deeper and more firmly rooted understanding of investing.

How Do Market Makers Work: FAQs

  • What is a Bitcoin Market Maker?

    A Bitcoin market maker operates the same way a regular market maker does - but in this case, liquidity is being provided to the cryptocurrency market, Bitcoin in particular.

  • Are All Brokers Market Makers?

    No - not all brokers are market makers, although that can be the case. An investor should always make sure whether or not a broker is also a market maker before opening an account.

  • How Do I Become a Market Maker?

    It is possible to become a market maker by registering with an exchange - however, keep in mind that this entails a lot of education, testing, and training. Most market makers work for large institutions.

  • How Do Market Makers Manipulate Crypto?

    Market makers can manipulate cryptocurrency market by constructing the illusion that great demand exists where it does not.

  • How Much Does a Market Maker Make?

    Market makers charge the difference between the bid price and ask price (otherwise known as the spread). Employees who work as “market makers” earn a median income of $62,150 per year.

  • Do All Stocks Have Market Makers?

    Whether or not a stock has a market maker will depend on the exchange it is listed on - but most stocks on all exchanges worldwide do have a market maker.

  • How Can I Avoid Market Makers?

    Market makers can be avoided by using a direct stock purchase plan, although in most cases, it isn’t worth it due to being time-consuming and more expensive.

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