A market maker is a financial institution that plays a crucial role in facilitating trading activities in financial markets. Market makers provide liquidity by quoting bid and ask prices for a particular security or financial instrument, thereby creating a market for buyers and sellers to transact.
Here are some key characteristics and functions of market makers:
Liquidity Provision
Market makers continuously quote bid and ask prices for securities or financial instruments, indicating the prices at which they are willing to buy and sell. This helps ensure that there is a readily available market for investors to buy or sell their assets.
Bid-Ask Spread
Market makers make money by profiting from the bid-ask spread, which is the difference between the price at which they are willing to buy (bid) and sell (ask) an asset. The bid-ask spread represents their compensation for providing liquidity and taking on the risk of holding inventory.
Stabilizing Prices
Market makers help stabilize prices by absorbing excess buying or selling pressure. If there is an imbalance in supply and demand, market makers can step in and trade with the other party to maintain orderly and efficient markets.
Quoting Obligations
In some markets, market makers have obligations to provide quotes and maintain liquidity within certain parameters. This helps ensure that there is sufficient liquidity even during periods of volatility or low trading activity.
Arbitrage Opportunities
Market makers may also engage in arbitrage strategies, taking advantage of price discrepancies between different markets or exchanges. This helps align prices and increases market efficiency.
Information Providers
Market makers often have access to valuable market data and insights due to their active involvement in trading activities. This information can be used to provide market analysis and insights to clients or other market participants.
Risk Management
Market makers manage their risk exposure by continuously monitoring their positions and adjusting their quotes based on market conditions. They may also hedge their positions to offset potential losses.
It's important to note that market makers operate within the framework and regulations of the specific financial market they operate in. Their activities are designed to enhance market liquidity and efficiency, and facilitate smooth trading operations.
The modern financial market cannot function without such a professional participant as a market maker, because round-the-clock trading includes illiquid periods when there are sharp imbalances in supply and demand, and if we allow the market to independently determine prices in such periods, we can observe increased volatility and price manipulation, which can be very significant, which would be regarded by market participants as an increased risk of trading, equal to an illiquid instrument.