Market Maker Definition: What It Means and How They Make Money

What Is a Market Maker?

The term "market maker" refers to a firm or individual who actively quotes both sides of a market in a particular security by providing bids and offers (known as asks) along with the market size of each. In fact, they are obligated to engage in such trading activity.

Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread. They may also trade for their own accounts. Such trades are known as principal trades.

Understanding Market Makers

Many market makers are brokerage houses that provide trading services for investors. They make markets in an effort to keep financial markets liquid.

A market maker can also be an individual trader, who is commonly known as a local. The vast majority of such market makers work on behalf of large institutions due to the lot sizes needed to facilitate the volume of purchases and sales.

How They Work

Each market maker displays buy and sell quotations (two-sided markets) for a guaranteed number of shares. Once the market maker receives an order from a buyer, they immediately sell their position of shares from their own inventory. This allows them to complete the order.

A market maker must commit to continuously quoting prices at which it will buy (or bid for) and sell (or ask for) securities. Market makers must also quote the volume in which they're willing to trade along with the frequency of time they will quote at the best bid and best offer prices.

Market makers must stick to these parameters at all times, no matter what their market outlook. When markets become erratic or volatile, market makers must remain disciplined in order to continue facilitating smooth transactions.

Regulation

Market makers must operate under a given exchange's bylaws, which are approved by a country's securities regulator. In the United States, that regulator is the Securities and Exchange Commission (SEC). The rights and responsibilities of market makers vary by exchange and by the type of financial instrument they trade, such as equities or options.

How Market Makers Earn Revenue

Market makers are compensated for the risk of holding securities (that they make markets for) that may decline in value after they're purchased from sellers and before they're sold to buyers.

In addition, they earn money from the aforementioned spread on each security they cover. For example, when an investor searches for a stock using an online brokerage firm, it might observe a bid price of $100 and an ask price of $100.05. This means the broker purchases the stock for $100, then sells it to buyers for $100.05. Through high-volume trading, a small spread can add up to a large amount of daily revenue.

Market Makers vs. Designated Market Makers

Many exchanges use a system of market makers who compete to set the best bid or offer so they can win the business of incoming orders. But some entities, such as the New York Stock Exchange (NYSE), have what's called a designated market maker (DMM) system instead.

Previously referred to as specialists, DMMs are essentially lone market makers with a monopoly on the order flow of a particular security or securities. Because the NYSE is an auction market, bids and asks are competitively forwarded by investors.

Here's how it works: The DMM posts these bids and asks for the entire market to see and ensures they are reported in an accurate and timely manner. They also make sure that the best price is always maintained, that all marketable trades are executed, and that order is maintained on the floor.

The DMM must also set the opening price for the stock each morning, which can differ from the previous day's closing price based on after-hours news and events. They determine the correct market price based on supply and demand.

Market Makers by Exchange

As noted above, market makers provide trading services for investors who participate in the securities market. Their activities through their entity trading accounts produce and boost liquidity within the markets.

Exchanges throughout the world make use of market makers. Here are some of the most popular ones:

NYSE and Nasdaq

The NYSE and Nasdaq are the two main stock exchanges in the U.S. Both are based in New York.

According to the NYSE, a market maker is an "ETP holder or firm that has registered" to trade securities with the exchange.

Over at the Nasdaq, a market maker is a "member firm that buys and sells securities at prices it displays in NASDAQ for its own account (principal trades) and for customer accounts (agency trades)."

Some of the designated market makers in New York include:

• Citadel Securities LLC
• GTS Securities LLC
• Virtu Americas LLC
  

Frankfurt Stock Exchange

The Frankfurt Stock Exchange (FRA) is one of seven stock exchanges in Germany. It is also the largest. The exchange, which is operated by Deutsche Börse AG, calls its market makers designated sponsors.

The following are some of the names of market makers on Xetra, which is the electronic trading platform of the exchange group:

• Berenberg
• JPMorgan
• Morgan Stanley
• Optiver
• UBS Europe
  

London Stock Exchange Group

London is home to one of the largest stock exchange groups in Europe. The London Stock Exchange (LSE) is part of the London Stock Exchange Group. This group also includes the family of FTSE Russell Indexes and the group's clearing services.

The following are some of the key market makers in this part of the world:

• BNP Paribas
• GMP Securities Europe
• Liberium Capital
• Mediobanca
• Standard Chartered
  

Tokyo Exchange Group

The Tokyo Exchange Group combined the Tokyo Stock Exchange and the Osaka Securities Exchange into one unit in 2013. In addition to infrastructure and data, the group provides "market users with reliable venues for trading listed securities and derivatives instruments."

According to JPX, the following are some of the key names among market makers:

• ABN AMRO Clearing
• Nissan Securities
• Nomura Securities
• Phillip Securities
• Societe Generale

Toronto Stock Exchange

Toronto is considered to be Canada's financial capital, and it's the location of the country's leading stock exchange. The Toronto Stock Exchange (TSX), which is the country's largest exchange, is owned by TMX Group.

The TSX lists the following among its market makers:

• BMO Nesbitt Burns
• Integral Wealth Solutions
• Questrade
• Scotia Capital
• TD Securities

Example of a Market Maker

Let's say there's a market maker in XYZ stock. They may provide a quote of $10.00 - $10.05 or 100 x 500. This means that they bid (they will buy) 100 shares at $10.00. They'll also offer (they will sell) 500 shares at $10.05. Other market participants may then buy (lift the offer) from the market maker at $10.05 or sell to them (hit the bid) at $10.00.

The Bottom Line

Market makers provide assurance to the investment community that trading activities can operate smoothly. Whether an entity or individual, market makers are obligated to provide bids and offers for securities—that is, to make markets—so that markets retain some degree of liquidity and investors can continue to buy and sell.