What Is a Market Maker and Why Are They Important?

Stocks, securities, and other assets need markets to move from sellers to buyers. And to ensure market liquidity when, for example, the offer exceeds demand, an intermediary is necessary. That's where a market maker steps in, ready to buy or sell stocks or securities at any time and generate income from the price difference. 

But, what is a market maker exactly? Read on to learn how they conduct business and stabilize the market.

Market Maker Definition and Significance

The term market maker refers to a company – typically a bank or a brokerage house – or an individual ready to buy and sell stocks or securities at any time. This means they are high-volume traders who act as intermediaries between sellers and buyers.

Market makers regularly update prices at which they're ready to trade and the amounts of securities they're willing to sell or buy at those prices. Thus, they provide bids when purchasing and asks when selling, which means they generate income from the bid-ask spread.

Moreover, market makers ensure liquidity since demand may not instantly meet the offer from a potential buyer when a seller announces the sale of stocks or securities. That way, they help bypass the discrepancy between the assets on offer and those in demand, acting as market creators.

Who Can Act as a Market Maker?

Market makers could be member firms of a securities exchange and individual participants, also called locals.

What Are Securities and Stocks?

Before proceeding further, let's define stocks and securities, as it’s what market makers deal in. 

Securities are financial assets available for trade. They come in the form of equity, debt, and derivatives. 

• Stocks are equities shared between the company's shareholders. Namely, stocks provide income for their owners, known as dividends, but their value tends to rise or fall.
• Debts include banknotes and bonds issued for money-raising purposes.  
• Derivatives encompass futures and options.

Understanding Market Making

Market makers ensure the liquidity of financial markets since they trade in options – contracts giving them the right to buy and sell on the stock exchange within a specified timeframe. But how exactly do they ensure that trading unfolds smoothly?

Types of Trading

Note that market makers can conduct principal or agency trading. The former is for their own benefit, while the latter is done on their client's behalf. Thus, they take on the risk of engaging in principal trading so they could earn more. On the other hand, agency trading eliminates dangers in case of market disturbances but also lowers the potential gain. 

How Market Makers Quote Bids, Asks, and Volumes

Market makers are always ready to trade at least 100 shares of any stock whenever they appear on the financial market. And each of them quotes prices for which they are willing to buy or sell a guaranteed number of shares, being obliged to quote both prices for their trades at all times.

Typically, market makers have stocks and securities in their inventory because they buy them from sellers at the quoted prices, whether or not a potential buyer is available. Then, upon receiving a buying order, market makers sell these assets. And that's what market making in stocks and securities essentially is.

So, options market makers ensure depth in the options exchange alongside market liquidity. Buying stocks and securities when the demand is low makes them readily available whenever an interested buyer appears. All in all, fewer transactions would occur without market makers.

But what happens if the price of assets falls before the trader sells them? In agency trading, the market maker gets compensation from clients for stocks whose price drops. However, if the market maker has chosen principal trading, they must be good at predicting how well the stock will fare since they bear the entire risk.

Market Maker Example

Let’s say a seller has sold 1,000 stocks to a market maker who has bought them at $10, the bidding price at the time. When a buyer who wants to buy the entire stock appears, the market maker sells these 1,000 stocks for $10.1, the quoted ask price. Thus, the intermediary earns $100 for this particular transaction, which is the bid-ask spread in this case. 

Of course, trades may involve far fewer stocks and smaller differences between the bid and ask prices. Nevertheless, market makers can earn substantial sums by making a number of small-scale transactions. 

Why Are Market Makers Important?

Market makers can influence the prices of securities based on supply and demand. As they can control the amount of securities in a particular market, they can correct the price by:

• Increasing the cost of undervalued stocks and
• Decreasing the cost of overvalued stocks.

What Is the Difference Between Market Maker and Broker?

Unlike market makers, brokers connect buyers and sellers, earning a commission for the deals they make possible. This means brokers make asset trading easier for buyers and sellers alike. Another difference is that they never buy or sell stocks for themselves. 

Conversely, market makers create an environment where investors engage in securities trade and can trade for their own benefit. 

Conclusion

In line with everything we discussed so far, we could define a market maker as an entity – company or individual – facilitating security and stock exchange in financial markets. They mediate between sellers and buyers, generating income from the bid/ask price difference.

Moreover, market makers influence the market in positive ways by:

• Ensuring flawless asset circulation from sellers to buyers by storing these assets in their inventories at times when the demand doesn't meet the offer, and
• Controlling the prices by decreasing overvalued and increasing undervalued stocks.

Ultimately, market makers make money by engaging in:

• Agency trading, which offers higher security but limits income to some extent, or
• Principal trading, which may be more lucrative but brings considerable business risks due to the highly volatile nature of the market.