Market maker

A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.^[1] From a market microstructure theory standpoint, market makers are net sellers of an option to be adversely selected at a premium proportional to the trading range at which they are willing to provide liquidity.^[2]

In currency exchange

Most foreign exchange trading firms are market makers^[3] 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 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) where FX is traded.

In stock exchange

Most stock exchanges 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 (NYSE) and American Stock Exchange (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 advantages.

Other U.S. exchanges, most prominently the NASDAQ 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 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.^{[citation needed]}

There are over two thousand market makers in the USA^[4] and over a hundred in Canada.^[5]

London

On the London Stock Exchange (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) system and it is they who generally deal with brokers 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 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,^[6] Liberum Capital, Shore Capital, Fairfax IS and Altium Securities.

Prior to the Big Bang, jobbers 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
• Day trading
• List of finance topics
• Divide and choose, analogous to a two-way price

References

1. ^ Radcliffe, Robert C. (1997). Investment: Concepts, Analysis, Strategy. Addison-Wesley Educational Publishers, Inc.. p. 134. ISBN 0-673-99988-2. 
2. ^ "Easley, López de Prado and O'Hara: The Exchange of Flow Toxicity", The Journal of Trading, Vol. 6, No. 2: pp. 8–13, Spring, 2011, SSRN 1748633 
3. ^ "Market Makers in Forex Trading". http://www.forexpromos.com/what-are-market-makers-in-forex-trading. 
4. ^ "List of U.S. market makers". http://www.alphatrade.com/techSupport/marketMakers.html. Retrieved 2008-10-31. 
5. ^ "List of market makers in Canada". http://www.alphatrade.com/techSupport/canadianIDs.html. Retrieved 2008-10-31. 
6. ^ www.wins.co.uk