Who Are Market Makers and What Do They Do?
By Mike Mc Mahon | January 16, 2020
How the Market Flows
In any business there needs to be managers to smooth the flow of commerce. The same is true in our various financial markets.
Who Are Market Makers?
The various managers, or market makers, in the financial markets all essentially play the same role. They are dealers in securities or other assets who undertake the task of buying or selling at specified prices at all times. This process is called Making a Market.
In most cases, they are considered day traders in that their companies wish to avoid overnight risk when the stock market is closed. So, they are buying and selling / selling and buying during regular trading hours and often placing transactions within seconds to minutes of each other.
Today, the activity of the market makers is cloaked using Electronic Communications Networks (ECNs). Prior to the late 1990s and early 2000s, anyone with Direct Access Trading (DAT) capability could literally see the market makers on the Depth of Market (Dome) such as NASDAQ’s Level II display. By identifying a large market maker like Goldman Sachs (GSCO) buying on the Bid, one had insight into which way order flow might be going. While no one trader market maker knew what everybody else was doing, even these little glimpses had to be eliminated and anonymity restored to further level the playing field.
Types of Market Makers
The Market Maker works in purely electronic exchanges where both institutional and public orders are matched by price. The price is guided by the market makers who have an interest in that particular security or asset. In other words, not all market makers work in the same arenas. For example, some may specialize in Biotechnology and ignore Retail sector items.
The market maker will guide the price based on their needs. The guidance is in the form of displayed size or a continuous pressure on the price at the BID/ASK point. Market makers’ activity can be seen at the Inside Bid and Ask as they adjust their willingness to buy and sell at specific prices. The market maker makes their living from the differential price between the Bid and the Ask. This is known as the Spread.
Another type of dealer that manages a market is called a Specialist. A specialist is a person who is a member of an Open Outcry stock exchange, such as the old style of the New York Stock Exchange. Their role is to facilitate trading in certain stocks. Specialists must make a market in the stock they trade by displaying their best bid and ask prices to the market during trading hours. They do this by stepping in with their own capital to help reduce market volatility when there are not enough buyers or sellers. The rules of the exchange prohibit specialists from trading ahead of investors who have placed orders to buy or sell a security at the same price. As Open Outcry markets are succumbing more and more to electronic trading, the role of the Specialist is becoming extinct and morphing into that of a Designated Market Maker.
Designated Market Maker
The Designated Market Maker is a market manager who is responsible for maintaining fair and orderly markets for an assigned set of listed equities. Formerly known as specialists, the designated market maker is the official market maker who must maintain proper liquidity in their assigned stocks. Often a designated market maker will take the other side of a trade when buying and selling imbalances occur. The designated market maker also serves as a specific point of contact for the listed company and provides that company with information on general market conditions, the mood of traders and the main traders of their stock.
How Do Market Makers Make Money?
Market Makers process orders for their own accounts, their internal customer accounts and work with investment banks to help pensions, mutual funds and hedge funds with their specific needs. In each case the market makers and designated market makers receive the difference between the transactions, the Spread, as well as often receiving a commission from larger clients.
As an example, a mutual fund cannot have more than a certain percentage of cash on hand at any given time. To meet the requirement, they may order a large Brokerage/Market Maker, like GSCO, to purchase 50,000 shares of Apple (AAPL). GSCO’s job is to get the best buy for themselves and for the mutual fund. The mutual fund will often pay as much $0.05/share to GSCO in addition to what GSCO made on the Spread.
Brokers vs. Market Makers - What is the Difference?
While all Market Makers and Designated Market Makers are Broker Dealers, not all Broker Dealers are market makers or designated market makers. The managerial status of a market maker requires additional funds, tests and approvals from the reigning powers, such as the Securities and Exchange Commission (SEC). Broker/Dealers are typically the public‘s avenue to the transactional marketplace, while the Market Makers and Designated Market Makers cater more to the institutional client.
About the Author
Mike Mc Mahon
Mike Mc Mahon was a co-founder of Online Trading Academy in 1997 and was Director of Education for 13 years. He is well versed in economics and has addressed the London School of Economics and participated in the Salon de L'Analyse in France. Though officially retired, Mike fulfills his passion for sharing knowledge by remaining a member of Online Trading Academy's content team.
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