Market Maker

Definition

A market maker is a financial institution or individual that stands ready to buy and sell a particular stock or other financial instrument on a regular and continuous basis at a publicly quoted price. They provide liquidity to the market and help facilitate trading by maintaining a two-sided market.

5 Must Know Facts For Your Next Test

1. Market makers help maintain orderly and efficient markets by providing continuous buy and sell quotes, even when there may not be a natural buyer and seller.
2. They earn the bid-ask spread as compensation for providing liquidity and taking on the risk of holding inventory of the security.
3. Market makers are obligated to maintain a two-sided market, meaning they must be willing to both buy and sell the security at their quoted prices.
4. The presence of multiple market makers for a security increases competition and can lead to tighter bid-ask spreads, benefiting investors.
5. In fast-moving or volatile markets, market makers may widen their bid-ask spreads to compensate for the increased risk of holding inventory.

Review Questions

• Explain the role of a market maker in facilitating trading and providing liquidity in a securities exchange.
  • Market makers play a crucial role in facilitating trading and providing liquidity in securities exchanges. By standing ready to continuously buy and sell a particular security at publicly quoted prices, they help maintain orderly and efficient markets, even when there may not be a natural buyer and seller present. This liquidity provision is essential for enabling investors to quickly enter and exit positions without significantly impacting the market price. Market makers earn the bid-ask spread as compensation for taking on the risk of holding inventory of the security and providing this valuable service to the market.
• Describe how the presence of multiple market makers for a security can impact the trading environment.
  • The presence of multiple market makers for a security increases competition, which can lead to tighter bid-ask spreads. This benefits investors by reducing the cost of trading the security. With more than one market maker, investors have a greater choice of prices at which they can buy and sell, leading to more efficient price discovery. Additionally, the competition among market makers can incentivize them to provide more accurate and timely quotes, further enhancing the overall trading environment for the security.
• Analyze how market makers may adjust their behavior in response to changes in market conditions, such as increased volatility.
  • In fast-moving or volatile market conditions, market makers may adjust their behavior to manage the increased risk of holding inventory. Specifically, they may widen their bid-ask spreads to compensate for this higher risk. By widening the spread, market makers are able to generate more revenue from the bid-ask differential, which helps offset the potential losses they could incur from holding inventory during periods of heightened volatility. This adjustment in the bid-ask spread is a way for market makers to maintain their presence and continue providing liquidity to the market, even in challenging circumstances.

Related terms

Bid-Ask Spread:

The difference between the price a market maker is willing to pay for a security (the bid price) and the price they are willing to sell it for (the ask price).

Liquidity:

The ability to quickly buy or sell a security without significantly affecting its market price.

Order Book: The electronic list of buy and sell orders for a security, organized by price level, that is maintained by the exchange or market maker.