What Exactly Is a Market Maker?

To grasp the concept of a market maker, imagine you’ve returned from a month-long expedition in the 16th century, loaded with exotic spices. Your immediate challenges are to find buyers and set a fair price for your goods. However, finding eager buyers right away is unlikely. You want to cash in immediately, given your exhaustion from the journey.

This is where a market maker steps in — acting as an intermediary that provides liquidity by being both a buyer and a seller. To sell your spices, you would approach a market maker who offers you a price. The market maker then seeks out buyers, shouldering the risk of holding inventory.

Can You Create a Market?

In today’s trading environment, when buying Gamestop stock, most investors are 'market taking,' which means they are accepting the prevailing bid-ask spread. For instance, if you log into your trading account and see that the bid-ask spread for GME is $99-$101, here's what you're doing:

A 'bid' represents the highest price a buyer is willing to pay, while an 'ask' is the lowest price a seller is willing to accept. If you choose to buy, you’ll pay $101, and conversely, if you sell, you'll receive $99.

Given supply and demand, the 'fair value' of the stock at that time falls somewhere between $99 and $101. Therefore, when using a 'zero-fee brokerage,' you’re effectively paying a hidden fee of $1 through the spread, even as you avoid explicit brokerage charges.

Market makers establish the bid-ask spread and ensure liquidity, even in volatile conditions. Ideally, they aim to match buyers with sellers, minimizing their risk of holding inventory. However, this is not always achievable, and they earn their profits from the spread as compensation for taking on that risk.

A common misconception is that market makers engage in 'front-running,' which involves exploiting non-public information to manipulate stock prices. This practice is not only false but also illegal. Having participated in numerous compliance briefings, I assure you that market makers are not willing to risk legal repercussions.

The outcome is beneficial for consumers, as they gain immediate access to liquidity, and competition among market makers helps keep the bid-ask spread as narrow as possible.

How Do Market Makers Generate Revenue?

As previously discussed, market makers profit by effectively matching buyers and sellers, reaping the benefits from the spread. For instance, if Jane Street sells 150 Apple shares to a buyer, their position becomes -150 shares. Later, if another seller offloads 120 shares, their position shifts to +120 shares. This results in a net position of short 30 shares.

If the spread on Apple shares is 10 cents, the market maker earns $12 from these two transactions. As long as they can maintain a balance between buyers and sellers, they can continue to profit. However, they must manage their risk carefully, as fluctuations in stock prices can lead to losses.

Market making requires a delicate balance; if spreads are too tight, they risk incurring losses, while overly wide spreads can lead to a lack of executed orders. Typically, wider spreads indicate higher volatility in a stock.

An ideal market maker effectively manages risk while maximizing trading volume, which is where high-frequency trading (HFT) comes into play. HFT firms use advanced algorithms to execute trades at lightning speed, allowing them to outpace competitors.

Top-tier market makers handle trillions in order flow annually, earning substantial revenue through minuscule spreads. However, after factoring in risks, many market makers find it challenging to remain profitable in this fiercely competitive arena.

The Exchange's Function

Now that we understand how market makers earn their money, let's explore the role of exchanges in this ecosystem. An exchange serves as a platform for trading activities, encompassing stock exchanges like the New York Stock Exchange and cryptocurrency exchanges such as Bitmex.

Different exchanges utilize various business models, but many adopt a 'maker-taker' approach. For example, Bitmex imposes a maker fee of -0.025% and a taker fee of 0.075% for Bitcoin transactions. This structure incentivizes market makers to provide liquidity while charging ordinary traders a fee when they cross the spread.

The maker-taker model encourages market makers to enhance liquidity on their platforms, attracting more participants. In the early days of Bitcoin, the lack of liquidity hindered transactions on reliable exchanges. Consequently, exchanges profit from the maker-taker spread, which is crucial to their business model.

Are Market Makers Beneficial?

The intense competition among market makers ultimately benefits consumers, as numerous firms vie for order flow. This dynamic forms the backbone of many exchanges and retail brokerage services, enabling extremely low-cost trading options.

Market makers play a vital role in establishing liquidity in emerging markets, including cryptocurrencies and real estate platforms like Zillow. They also contribute to market stability during crises, as demonstrated by Jane Street's efforts to maintain liquidity in the bond ETF market during the 2020 downturn.

Furthermore, market makers operate under stringent regulations, such as SEC Rule 605, which outlines their obligations. Regulatory data indicates that retail traders saved $3.6 billion in 2020, partly due to the lower trading costs associated with market makers.

To learn more about finance and decision-making, join over 1,000 readers who receive insights from my experiences as a derivatives trader on Wall Street. This article was originally published on my website, christopherjgan.com. Follow me on Twitter for more updates.

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Footnotes

[1] Citadel refers to the hedge fund, while Citadel Securities operates as the market-making subsidiary. Robinhood sells order flow to Citadel Securities, which lent funds to Melvin Capital for the Gamestop short.

[2] High-frequency trading (HFT) typically involves proprietary trading firms executing trades rapidly through automated systems, akin to the fast-paced trading of the past.

[3] Market makers are obligated to act as buyers or sellers, which can lead to selection bias where they often find themselves on the less favorable side of trades. The spread serves as a buffer to help them manage this risk.

[4] When exchanging currency, one often encounters exorbitant spreads at Forex counters, leading to significant losses. For example, a $1,000 exchange could result in over $50 in fees, while currency markets often offer much tighter spreads.

[5] Revenue from a $1 trillion order flow at a 0.50% spread equals $5 billion.

[6] In 2020, Jane Street executed trades amounting to over $17 trillion.

The first video, "What Exactly Do Market Makers Do? (& How They Manipulate The Market)," explains the functions of market makers and addresses common misconceptions.

The second video, "4 Lessons Learned My First Year As a Market Maker. Surviving and Growing In Bad Markets," shares valuable insights from the author's experiences in market making.