Market makers fulfil a crucial role in the world of trading. They provide liquidity in the market and ensure a buyer and a seller of an asset can always make the trade.
But how do they work exactly? Let’s break it down.
What is a market maker?
Market makers are third parties that provide the means for people to buy or sell assets.
There is nothing stopping two parties from directly carrying out a trade. But what happens if a buyer or a seller can’t agree on the price or quantity of an asset they wish to transact? This is the situation in which a market maker performs a critical role.
Market makers hold an inventory of a particular asset. They either sell from this when they receive a buy order, or they add to it when they receive an instruction to sell. This ensures that financial markets can keep moving and that a buyer and a seller can always find someone to trade with.
Market makers come in a variety of sizes. They are often banks or brokerage houses, though they can also be individuals. When a buyer and a seller wish to make a trade, they contact their broker, who in turn gets in touch with a market maker. The latter then provides quotes on the amounts at which they will buy or sell a particular asset.
How do market makers set prices?
Market makers provide two prices when approached by a broker. One is the price at which they are prepared to buy an asset. The second is the price at which they are content to sell.
Like any other product or service that is traded, the prices set by market makers are influenced by the level of supply and demand.
An example of setting prices
So how does this work in practice? Let’s say that, in a market where supply and demand is evenly balanced, a marker maker prices a UK stock at 199p-200p. This means that they are prepared to buy the share at 199p and to sell it at 200p.
Now let’s say that some negative news comes in about the company. For example, earnings could come in lower than forecast, a common reason for a sharp increase in the number of sellers.
Suddenly that UK stock may not look as attractive to buyers with a bid price of 199p. This means that the number of buy orders might dry up. Meanwhile, to sellers, an ask price of 200p might appear extremely favourable in light of that bad news. So brokers could receive an influx of sell orders.
At 199p-200p, the shares are no longer in a state of supply and demand balance. To restore market equilibrium, a market maker will have to adjust the bid-ask spread to eliminate the gulf between the level of buyers and sellers.
A market maker might have to amend the spread multiple times before supply and demand reach equilibrium again. For example, they might begin by pricing a share at 198p-199p. And they might find that the number of buy orders doesn’t match the number of sell orders until the price gets down to, say, 194p-195p.
At this point, they will settle on this new price. But remember that markets don’t sit still for long. A vast number of economic, industry, and company-specific factors are always competing at any one time to pull a UK stock’s bid-ask spread one way or another. The art of market making involves responding to this in a timely manner and displaying up-to-date prices.
How do market makers make money?
Market makers generate profit through what is known as the ‘bid-ask spread.’ As the name suggests, this is the difference between the price the buyer of an asset will offer (the bid price) and the price the seller will accept (the ask price). The market maker pockets the difference between these two prices when they complete a transaction.
Fortunately for investors, there is a high degree of competition between market makers. This ensures that the bid-ask spread does not become too pronounced, which is to the obvious benefit of buyers and sellers.
On paper, the difference between bid prices and asking prices might look that small. However, market makers are still able to make large profits from their activities due to the colossal number of trades that they execute.
An example of market making profits
Let’s say that Lloyds Banking Group (LSE: LLOY) shares are trading at 45p per share. A market maker might offer a bid price (the price at which they’re prepared to buy) of 44p and an ask price (the price at which they’re willing to sell) of 46p.
That bid-ask spread doesn’t look particularly large, right? But once you consider that Lloyds shares trade at colossal volumes, then the lucrative business of market making becomes apparent.
Let’s say that 158m of the bank’s shares were bought and sold. That 2p difference between Lloyds’ bid and ask prices, then, could see market makers generate a profit of £3,160,000 if they processed every order. That’s assuming that they dealt with every trade in Lloyds shares, of course.
And remember that Lloyds is just one of thousands of shares that trade on the London Stock Exchange every day.
How does market making help investors?
Market makers are an essential cog in the wheel of maintaining high levels of market liquidity. Without them, global stock markets wouldn’t experience the colossal trading volumes that they currently do.
The presence of a market maker means that there is always someone there to buy and sell certain assets. They keep markets moving even when there isn’t a buyer and a seller lined up immediately. Without them, a transaction could take a long time complete. A delay could occur if, for example, a buyer and a seller could not agree on a price or the number of shares to be transacted.
Basically, market makers keep the market moving as we know it.