The importance of a market maker in the stock market cannot be understated. Participants in an exchange rely upon them for liquidity. Market Makers may be a firm or individual providing the vital service of infusing liquidity in the market. In exchange for their service, they earn small spreads.
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What is a Market Maker?
Market makers are companies that improve the liquidity and trade volume of stocks on a given exchange. However, when working as market manipulators, they must follow specific laws set by the country’s regulators to operate legally. Usually, they work in groups to subsequently bring more buyers and sellers into the market.
Market makers are essential to any financial market and subsequently, they work as per the instructions from securities market regulators. They provide quotes for stocks and process buy and sell orders from investors. Therefore, they are responsible for executing orders received from investors.
In an effort to combat the risks of trading, market makers are given the benefit of a two-way quote. Consequently, they offer to buy and sell prices together in a quote. The profit from a difference in the prices is a reward they earn for taking the risk.
Who is a Market Maker?
A market maker can be an individual or an entity formed by a group of market makers. They hold an inventory of securities or even physical currencies for trade. During a trade, they provide investors with better prices.
How do Market Makers Work?
Market makers buy and sell stocks as a part of a brokerage firm or as an individual. They help exchanges to set the best bid or offer on a counter. Following are the categories of market-making firms:
Retail Market Makers
Retail brokerage firms employ market makers to keep stocks liquid. They make prices more efficient for retail traders and keep the order flow moving. They earn profits from the bid-ask spread and get their brokerage cuts from even commission-free trades.
Institutional Market Makers
Market makers working on large block orders for mutual funds are known as Institutional market makers. They maintain capital inventory for pension funds, insurance, and other investment assets.
Wholesale market makers focus on high-volume pools and use order flow arrangements. They trade securities for both institutional clients and broker-dealers. These market makers create optimised bundle orders using high-frequency trading algorithms.
Learn: What is Liquidity Trap?
What is the Role of a Market Maker in the Market?
The role of a market maker in the market is to ensure liquidity. They do so by giving buy and sell quotes which automatically create liquidity in the market. A bid-ask table shows the gap between the best buy price and best sell price. If the difference between these prices is low, the risk in trading such counters reduces.
Market makers operate as key market participants to earn profits from the difference amount. They give buy and sell quotes to create a spread and then earn from trading volumes on a daily basis. Their trades involve a large risk as there is no guarantee of execution of both sides of the transaction.
How do Market Makers Impact Liquidity?
The presence of market makers makes stock trading safer and more secure. They create volumes in stocks and keep the markets from becoming illiquid. The two-way quotes provided by them reduce the basis risk and trading risk for market players. To keep the market risk lower, they reduce market volatility and provide liquidity. BSE and MCX-SX (now MSEI) have even incentivized market maker services.