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What Is a Market Maker? Definition, Function & Importance

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What Is a Market Maker? Definition, Function & Importance


Market makers provide liquidity by holding large amounts of stock and being willing to fulfill buy and sell orders quickly.

Contents

What Are Market Makers and What Do They Do?

When investors and traders buy shares of stock, those shares have to come from somewhere. When they sell shares of stock, those stocks have to go somewhere. This is where market makers come in—these are individuals or entities that provide the market with liquidity by holding a large number of shares of a particular stock and being willing to buy or sell shares at any given time.

Market makers are what allow buy and sell orders placed by individual and institutional investors to be executed quickly. Both the NYSE and the Nasdaq—the two largest stock exchanges in the world by trading volume—use market makers to maintain an orderly exchange (although they do so in slightly different ways).

For any given stock, a market maker quotes two prices: an ask, which is a higher price they are willing to sell shares for, and a bid, which is a lower price they are willing to buy shares for. The difference between these two prices is known as the bid-ask spread.

How Do Market Makers Facilitate Efficient Trading?

By holding large numbers of shares and being willing to buy or sell shares at any time, market makers create liquidity for the stock or stocks they work with. Stocks that are liquid are easy to buy and sell quickly, and the liquidity provided by market makers is in large part what allows stocks to trade efficiently between individuals, corporations, institutional investors, and other players in the stock market.

How Do Market Makers Make Money?

Market makers quote two prices for any given stock at any given time. Their bid is the price they are willing to pay for a share of a particular stock, and their ask is the price at which they are willing to sell a share of that same stock. For any given stock, a market maker’s ask is always higher than its bid.

By buying shares of stock at one lower price and selling shares of the same stock at a slightly higher price, market profit by facilitating many buy and sell orders over time. This is their incentive to participate in the market: They provide liquidity for traders, and in return, they get to pocket the bid-ask spread for the stock or stocks they work with many times over.

How Do Market Makers Work in an Auction Market Like the NYSE?

The NYSE, America’s oldest stock exchange, functions as an auction market, meaning bids and asks are analyzed and matched to execute trades. Within the NYSE, market makers were formerly known as “specialists” but are now referred to as designated market makers or DMMs.

DMMs on the NYSE specialize in one or more stocks for which they facilitate fair and orderly trading by providing the following services:

The DMM is responsible for posting all bids and asks and executing all viable trades at the best market price. The DMM sets the opening price for the stock they specialize in. Sometimes this price matches the previous session’s close, while other times, it is adjusted based on after-hours news and events. The DMM is responsible for accepting, managing, and executing all limit orders for the stock in question. The DMM must equalize buy and sell interest in the stock they specialize in by buying large numbers of shares during selloffs and selling large numbers of shares from their own inventory during periods of increased buying interest.

How Do Market Makers Work in a Dealer Market Like the Nasdaq?

The Nasdaq Exchange, America’s second-oldest stock exchange, operates as a dealer market. Here, market makers have somewhat simpler responsibilities. On the Nasdaq, large investment firms operate in competition with one another to ensure investors and traders can get the best available price when they buy and sell shares.

For any given stock, each market maker for that stock maintains an inventory of shares and provides public bid and ask quotes. Buyers and sellers are then matched electronically with the best price available at the time and their trade is executives.

Market Makers vs. Brokers: What’s the Difference?

Brokers are licensed professionals that buy and sell stocks on their clients’ behalf. In the past, most brokers were individuals who worked on commission and charged trading fees, but these days, many investors use discount brokers like Robinhood and WeBull, which allow for fee-free trading through an online brokerage platform. However, full-service brokers that provide financial advice and personalized services (and charge commissions) also exist. In short, a broker connects investors to stocks.

Market makers, on the other hand, are usually institutions like banks that hold large amounts of stock and are willing to buy and sell shares quickly so that trades can be made efficiently without individual buyers having to wait to be matched with individual sellers. In other words, market makers create the liquidity necessary for efficient trading, which is performed by brokers on behalf of their clients, the investors.

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