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What Is a Market Maker?


December 2021

Anyone who's generally familiar with trading has heard about buyers, sellers and brokers. But there's one type of market participant that often gets overlooked: market makers. If you want to do well in the trading world, you should learn who's running the financial markets and who stands in your way. In this guide, we'll cover everything from a broad definition to common myths and trading advice.

Anyone who's generally familiar with trading has heard about buyers, sellers and brokers. But there's one type of market participant that often gets overlooked: market makers.

If you want to do well in the trading world, you should learn who's running the financial markets and who stands in your way. In this guide, we'll cover everything from a broad definition to common myths and trading advice.

Market Maker Definition

Market makers are also referred to as liquidity providers, which vaguely explains what they do. Market makers are usually large banks or financial institutions that keep the market functional by infusing liquidity. In simple terms, they ensure financial assets can easily become 'usable' money. If you want to sell an asset, they're there to buy it. If you're going to buy an asset, they can sell it. In turn, they take a commission in the form of the bid-ask spread.

Market making is prevalent in currency exchange, where the participants tend to be banks and foreign exchange trading firms. In theory, an individual can also 'make a market', but the size of the investments needed is a huge hindrance. It takes enormous funds to be able to always stand at the ready to buy or sell.

Example of a Market Maker: Say the current market price of EUR/USD is $1.05. Suddenly, there's news indicating that the EUR is going to rise. This should prompt individual traders to place market orders at $1.05. However, there will likely be an influx of buy orders at some point. A market maker, anticipating this behaviour, sets the price at $1.10. Because of the high number of market orders, the market price may rise, let's say, to $1.15, and because of demand, fall back to $1.12. A market maker will then sell their EUR/USD inventory to meet peak demand at $1.15 and restock it when it drops to $1.12.

Types of Market Makers

We can distinguish three types of market makers by their specialisation: retail, institutional and wholesale.

How Do Market Makers Work?

Market makers control how many asset units (stock, currency, etc.) are available for the market. Based on the current supply and demand of said asset, they adjust the price. They provide liquidity for the order book by placing orders that can be matched in the future. Then, market takers (traders, for example) consume the inventory by taking the order from the order book.

Market makers are known to hold a disproportionately large number of assets. The reason why is they need to be ready for a high volume of orders in a short time at competitive pricing. If investors are buying, they're supposed to keep selling, and vice versa. They take the opposite side of trades being executed at any given time, i.e., acting as a counterparty.

Each market has its own market makers, which means that each broker uses a quote given by one or several market makers when offering prices to clients.

What Is the Role of a Market Maker?

To better understand what a market maker does, it's worth looking into the functions they perform in the market.

Intermediation

By intermediary function, we mean several ways of intervening in the market:

How Do Market Makers Make Money?

Market making is associated with risk brought over to trading books. To compensate for that risk, a market maker charges a fee in the form of commissions or the spread. Unlike traders, a market maker doesn't raise money by buying low or selling high.

Let's look closely at the two most important sources of market-making:

How Do Market Makers Make Money?

How Do Market Makers Make Money?

How to Become a Market Maker

Anyone can become a market maker/liquidity provider if they meet the requirements. The catch is that it's practically impossible for a regular person to perform minimum trading functions. More commonly, only a large institution can sustain the required volume of trading.

But if you're interested in the process of becoming a dedicated market maker, here's how it goes:

  1. Verify eligibility and become familiar with exchange expectations.
  2. Complete all necessary paperwork to get a market maker permit.
  3. Apply to authorised exchange staff.
  4. Provide proof for Guaranteed Minimum Fill for eligible orders.
  5. Wait for the solicitation and approval process.

If we look at the topic more broadly, we can disregard the official "market maker" title. In essence, any participant with a significant share of operational volume makes the market in a way.

Advantages and Disadvantages of Market Making

The advantages of the market maker concept are exciting for smaller accounts and private investors. As for disadvantages, they're primarily applicable to advanced traders.

Advantages

Disadvantages

Market Maker vs Broker

Let's avoid confusing market makers with brokers because they seem similar in many ways. The table below compares the two.

Market Maker

Broker

Acts as a source of liquidity for exchange-traded assets

Facilitates selling an asset to a seller and purchasing for a buyer

Large banks or financial institutions

Individuals or firms

Heavily influences the market

Doesn't have a direct effect on the market

Charges spreads between the price that traders receive and the one the market sets

Charges fees and commissions

Has deep market insight (an advance look at all incoming orders)

Possesses the same information as the rest of the market

Doesn't work for clients; instead, they create a market for investors

Provides services for clients (consulting research, investment advice)

List of the Largest Market Makers

Below is the list of market makers that are considered the largest in the world. Bear in mind that it's hard to compile their exact rating, but here are the companies that are worth traders' attention.

Myths About Market Makers

Most of us have heard the assumption that the market is manipulated by some power driving prices in whatever direction they need. If these claims come from newbies, it makes sense. However, blaming all losses on shadowy puppeteers can quickly become detrimental. Below are several myths that we can clarify.

Why Should Traders and Investors Be Aware of Market Making?

Market makers have a significant impact on the market and, hence, your trading success. Here's how you can use that to your advantage.

Conclusion

It's undeniable that the market maker's role is technically difficult but has real value for the market and exchanges. These participants must commit to maintaining fair prices for different types of assets and covering demand at any time. You may not have known it before, but market makers have always been present in financial markets. Otherwise, large-volume orders would only be executed with long delays, making trading impossible.

To get started on the right note, sign up for a demo account at Libertex. You can use it to practice and master your strategy in a simulated market.

When you upgrade to a live account, you'll already be accustomed to how the market works and make sound decisions. And thanks to market makers and our platform, you can open positions within a matter of seconds.But please note that trading CFDs with a multiplier can be risky and lead to losing all of your invested capital.

FAQ

Finally, here's a quick round-up for this topic.

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