Introduction to Market Maker
Market makers are financial intermediaries who are either ready to take up the buy or the sell position in a market transaction and therefore act as a counterparty by positing both buy and sell quotes and by building up the inventory of the securities to fulfil the requirements or act as the connecting point between buyers and sellers thereby providing liquidity to the traders.
Explanation of Market Maker
These market makers are mostly governed by the security regulators such as the SEC in the US or the SEBI in India and therefore they have to follow the guidelines of the regulators and act within them. They have a limit on the amount of inventory they can hold without affecting the integrity of the market and therefore when a large trade has to be executed, a number of market makers have to come together to fulfil the same.
They are required to provide liquidity in the market so that the trades can be executed at an optimal transaction cost and the markets can function seamlessly. If market makers are not available, then the number of transactions can be affected and over all investing can get reduced. It is similar to having a network of retail outlets for the products to be sold so that the buyers and sellers can reach out to their nearest shop to acquire goods and services.
Role of Market Maker
Depending upon the portfolio of the products and services provided, the market makers may play different roles in the market:
- Brokers: They act as financial intermediaries who connect buyer to sellers. They don’t trade themselves, they only provide a platform wherein the buyers can post a buy intention and a seller can post a sell intention and the broker helps them meet and execute the trades for them. The most important role here for the broker is to get his client the best possible execution and for the same they charge a fee or a commission from the client.
- Dealers: They act as the counterparty to the transaction. The buyers buy from the dealers and dealers fulfil the order from their own inventory while the sellers sell to dealers and the dealer builds up inventory. For them the main role is to fulfil the order for the trader. The dealer profits from the bid ask spread that is from the ‘buy low sell high’ phenomena
- Advisors & Investment Bankers: These can be those market participants who provide services to M&A or IPO clients for example the underwriters, securitizers and so on. They help in issue of securities of a company or in striking an M&A deal.
- Depositors: In case of securities such as the ADRs or GDRs the issuer and the investor come in contact through a depository participant who help the issuers in raising capital from the markets where they are not listed directly and help investors in gaining exposure to such securities
One of the important roles that the market makers play is that they provide liquidity in the market and help in execution of large trades. Most times they act on behalf of institutional investors who need large blocks of investment and therefore they would want the best execution for the same, however, it is not the case that the retail investors can’t get help from them, provided their fees are within the reach of smaller investors.
Examples of Market Maker
Below are a few market makers companies along with their 4 letter market maker codes for the NASDAQ in the US
- GSCO: Goldman Sachs & Co.
- MLCO: Merrill Lynch
- FBCO: Credit Suisse Securities LLC
- DBAB: Deutsche Bank Securities
- MSCO: Morgan Stanley & Co. Inc.
- JPHQ: JP Morgan Securities, Inc.
GSCO specializes in equity, fixed income, currency and commodity domains as a market maker to give an example and as part of this process, they take orders from clients, provide investment research, market information, analysis and other related products.
How Market Makers Make Money?
Two of the most important sources of market-making are the follows:
- Bid-ask Spread: For dealers, this is one of the main sources of profiting. Bid is the price they buy the securities at and ask is the price they sell them for. The difference between the two prices is known as the spread and that is the profit of the dealer before accounting for his expenses
- Commission or Fee: For brokers or advisors and investment bankers, one of the most important sources is the fee or the commission they take from their clients for the services they provide. These are fixed fee and therefore, most times they are not linked with performance in the interest of the client because otherwise, they may create a conflict of interest rather than incentivizing.
There can be other customized arrangements for income between the client and the market makers within the allowable guidelines of the regulators.
How Market Makers Impact Liquidity?
- Counterparty: It is not always possible that the buyer of a security may find a seller, and due to this timing difference, there can be great illiquidity in the market. The market maker such as the dealer builds up the inventory and therefore acts as a counterparty and thus removes the effect of this difference in timing.
- Block Trading: Market makers build up inventory and therefore they are able to execute large trades for institutional investors either individually or in group. These make investing possible for large investors without impacting the price in the market in normal course.
Advantages and Disadvantages
Below are mentioned the advantages and disadvantages:
Following are the advantages are given below:
- Investor Confidence: The presence of market makers brink investor confidence because that implies that the securities are worth investing in. Market makers have the expertise of analyzing securities from an angle that smaller investors can’t and therefore their activities act as a barometer for the securities in the market.
- Security Availability: Depositors make available securities that are not otherwise available to the investors and therefore they make investing in such securities easier and safer because they act as custodians and therefore help the investor in getting the exposures they desire.
- Seamless Markets: By bringing liquidity and volume in the market, the market makers help inefficient functioning of the markets.
Following are the disadvantages are given below:
- Conflict of Interest: Most times, the market makers function as brokers and dealers, this leads to a conflict of interest because as a broker they are supposed to get the clients the best execution while as dealers, they become the counterparties and therefore trade for profit. Creating such a divide within the organization is not an easy task and therefore the investor need to be cautious.
- Impact Market Integrity: Market makers deal in a large number of securities and therefore have the power to influence the price in the market and therefore their actions might impact the integrity of capital markets. Their actions may attract herding behavior in the investors and therefore such practices might not be good for the health of the market and investing as a whole.
- Insider Trading: Market makers have a lot of information that is not publicly available and therefore there is always a possibility that some individuals might indulge in insider trading and therefore make unfair profits which can lead to severe regulatory actions and innocent investors get affected for no fault of theirs.
Therefore we know that there are different types of market makers who fulfil different roles in the financial markets from acting as intermediary to the counterparty to advisors and so on. They help in creating liquidity, availability, volume in the market and make the markets run efficiently and seamlessly. They earn from fee or spread.
However, every coin has the other side too. They have greater information availability and the power to affect the markets and therefore they have great responsibility to maintain market integrity and act in the best interest of their clients by overcoming various kinds of conflicts of interests.
This is a guide to Market Maker. Here we also discuss the introduction to Market Maker and how these makers impact liquidity along with advantages and disadvantages. You may also have a look at the following articles to learn more –