Market makers have always been a very common subject of questions on the Fool's discussion boards, with questions ranging from the simple "How do market makers work?" to the heartfelt "The market makers have ripped me off, what legal redress do I have?"
So are they simply licensed parasites living off the backs of hard-working investors and manipulating share prices for their own benefit? Or do they provide a worthwhile service, exposing themselves to considerable risk, for which they deserve adequate compensation?
Many people seem to think that the former is the case, but hopefully you'll soon be convinced that the latter is far closer to the truth. The London Stock Exchange(LSE: LSE) is tightly regulated and relies on a reputation for honesty. Any misdeeds on the part of its market makers would be disastrous, and would be certain to be swiftly dealt with. Anyway, let's start out by looking at what market makers actually do...
For anything to be traded, there needs to be a market for it, and all that means is that there needs to be some mechanism for people who want to buy whatever to be able to contact people who want to sell, and whereby a deal can be struck. Individual people can't call around all of a company's shareholders to see who wants to buy or sell, and haggle with all of them to get the best price, no more than we can talk to all the world's fruit growers to find out who has the best price for grade 1 pomegranates today.
Pomegranates, of course, reach us via the retail distribution chain. Traditionally, this chain has consisted of wholesalers, who bring together the markets for certain goods, and the retailers who provide the service of comparing wholesalers and getting the best goods and prices for their customers. These days, the supermarkets are exerting more and more control over the whole supply chain, but the principle is intact.
In the world of shares, the market makers effectively provide the wholesale service, with our individual brokers providing the retail service we need for our individual buying and selling. Generally, a single market maker will only deal in the shares of a relatively small number of companies, the same way traditional wholesalers have specialised in building materials, fruit and vegetables, or whatever. Also, each company has a relatively small number of market makers dealing in its shares.
The market makers, then, provide the "go-betweens" that give our brokers a market in which to trade shares for us. So far so simple.
The biggest cause of worry for many is that market makers are thought of as the people who set the prices of shares, and some people feel that this is unjust and question why they should have the right to choose what price a company's shares trade at.
But market makers can only really be thought of as setting the price of shares in the most pedantic sense. The real thing that determines the price of a share is the balance of supply and demand for it, and the job of market makers is to set a price that balances that supply and demand, and thus keep the market for their shares as liquid as possible. At any one time, there is only going to be one price that will bring about that balance, and that is the price that the market makers have to find (actually, there is a buy/sell spread that the market makers set around the perfect price, but we will come on to that shortly).
Let's think about what happens if a market maker gets the price wrong. All market makers keep a float of shares on their books, but that isn't generally a huge amount. They try to minimise the size of the float they carry as a bigger float exposes them to more risk. (Unlike investors, market makers have to keep buying and selling the shares that they deal in regardless of how well the company is performing, and they can't just bale out when things start looking risky). But they need to keep a big enough float to satisfy short term demand too.
Market makers' pricing of shares works exactly the same way as the traditional demand and supply pricing model tells us that the prices of everyday commodities work. If the price is set too high, there will be more people wanting to sell their shares than wanting to buy, and the market maker will end up with a surplus of shares that can't be sold at the price. The price will therefore have to be lowered and doing this serves two purposes. It discourages some of the people who would otherwise want to sell their shares, while at the same time attracting new buyers. If the price set is the correct one, then the number of buyers will match the number of sellers and the market maker will end up with an acceptable size of float.
If the set price is too low, there will be more buyers than sellers and the market maker will run out of shares. So what is to be done then? Obviously, the price will have to be raised, discouraging some buyers and enticing more sellers until demand and supply balance once again.
The next thing to look at is how market makers make their money, and that's where the spread comes in. At any one time, a market maker will quote two prices; one at which you can buy and one at which you can sell. The former is, of course, the higher of the two, and the difference between them is the market maker's profit. Changes in the price of shares throughout the day don't really come into it much; if a market maker can manage to keep a constant float, it is only really the spread that provides the long term profits.
The size of the spread depends on a number of factors. For a large company, whose shares trade freely, and for which there is a large number of market makers (and large companies tend to have more market makers than small companies) the lower risk associated with the liquidity, and the competition generated by the large number of market makers, conspire to force the spread down, and the difference in the buying and selling price will be narrow.
With a small company, whose shares don't trade so freely and which has few market makers, the risk will be higher and the competition less intense, and so the spread will be wider.
Vodafone(LSE: VOD), one of the UK's largest companies, has over 400 market makers and a typical spread of just 0.5p. That's less than 0.3% of its price. However, many penny shares can have spreads of 10% or even higher. In fact some shares which have a price of just 1p or 2p can have spread of 50%, 75% or even 100%!
Hopefully, that all sounds logical so far, so let's now take a look at what the marker makers' obligations are when dealing with your broker. There is one core obligation; if a market maker quotes a buy or sell price to your broker, then there is an obligation to buy or sell shares at that quoted price, up to a limit. The limit is called the Normal Market Size (or NMS), and its magnitude depends on the same things that help determine the spread. A large company whose shares are easier to trade will usually have a larger NMS than a smaller company with less liquid shares. Vodafone has a normal market size of 200,000 shares, equivalent to around £350,000 of shares at the time of writing. Some penny shares have normal market sizes of just a 1,000 shares, and you may only be able to get the quoted price for up to £2,000 of shares, or even less.
Any purchase you want to make over and above the normal market size cannot be guaranteed to be met at the quoted price, and a higher price may need to be negotiated (and likewise, when selling more than the NMS you may have to sell at a lower price than that quoted).
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