What is a Market Maker?
Updated: 2 days ago
Market makers are omnipresent in everyday securities trading. They provide liquidity to the market by being continuously available to other trading participants for executions of buy and sell orders. They are known in the market under various names, such as specialists at the Frankfurt Stock Exchange (FWB) and the Skontroführer at the Hamburg Stock Exchange. However, the activity of the market maker is essentially the same: providing trading opportunities. This article gives an overview of market making and market maker funktions on stock exchanges.
Table of Contents
1. Definition of Market Making
The market maker is characterised by his activity, i.e. market making. German supervisory law defines market making as follows:
a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against that person’s proprietary capital at prices defined by that person
In addition to the regulatory definition, other market making definitions have emerged in economic academia. Some define market making as a trading strategy in which simultaneous buy and sell orders (quotes) are placed for a financial instrument in order to generate a return from the collection of the bid-ask spread. In addition, it is pointed out that market making also includes those trading strategies in which market makers do not provide quotes but, for example, simply offer to buy or sell in turn.
Some argue that only trading participants of a trading venue that offer buying and selling as part of an obligation to provide continuous liquidity shall fall under the term market maker. Such obligations may exist in particular vis-à-vis the trading venue operator or the issuer of a security. Some also argue that no quotation obligations need to be in place, but merely refer to an agreement under which the market maker receives rebates or other benefits in return for providing liquidity. Incentives for the provision of liquidity are not only granted in return for the fulfilment of quotation obligations, but partly also for the voluntary fulfilment of specific liquidity targets.
2. Distinction from Other Terms
The term market maker can be distinguished from other types of market participants or types of market participation, in particular from:
Liquidity Providers
High-Frequency Traders
a. Distinction from Liquidity Providers
The term liquidity provider is closely related to the term market maker. This is because every market maker provides liquidity to the market. However, not every liquidity provider is also a market maker.
In general, liquidity refers to how easy or difficult it is for market players to realise transaction interests without significantly affecting the price as a result. Liquidity improves when market players create transaction opportunities, for example, by placing a passive order in the order book within the framework of an order book system. In this way, basically anyone can make trading more liquid.
In some cases, the term is used for market makers who are obligated to quote to the trading venue operator to a certain extent. In other cases, the term is used to describe market makers who only receive financial incentives in the event that certain targets are met, but who are not subject to quotation obligations.
However, there is no legal definition of a liquidity provider. It is also possible to call a market maker a liquidity provider whenever it places an order in the order book or causes this to happen, thereby making trading more liquid.
b. Distinction from High-Frequency Traders
Another term that is closely related to the market maker is the high-frequency trader, who is essentially characterised by the use of algorithmic trading techniques in which price differences are exploited in the short term through a high number of executions, using a technical infrastructure that reduces latency. Within this framework, the respective algorithm executes classical trading strategies, such as market making and arbitrage. A high-frequency trader can, but must noch be a market maker.
3. Economics of Market Making
Market makers continuously provide liquidity to markets in financial instruments, i.e. continuously provide tradable prices. Market making itself is a trading strategy and has a certain proximity to passive arbitrage strategies and passive short-term investments. Nevertheless, market making can be distinguished from other trading strategies by its specific characteristics (especially valuation indifference and risk aversion).
In 1968, the economist Demsetz laid an important theoretical foundation for market making. He described market-making as a service to other market participants by providing "predictable immediacy":
Predictable immediacy is a rarity in human actions, and to approximate it requires that costs be borne by persons who specialize in standing ready and waiting to trade with the incoming orders of those who demand immediate servicing of their orders. The ask-bid spread is the markup that is paid for predictable immediacy of exchange in organized markets; in other markets, it is the inventory markup of retailer or wholesaler.
a. Valuation Indifference
Within an order book system, market makers offer the immediate realisation of transaction interests by placing limit orders or quotes in the order book. They make a trading profit if they buy at a price that is lower than the price at which they sell. The trading profit expected by the market maker materialises in the spread he quotes, i.e. the spread between the respective buy and sell prices.
Since it is important for the market maker to achieve a trading profit from the collection of the spread, he measures the respective prices in such a way that, if possible, he achieves purchases and sales corresponding to the volume within a short period of time. This in turn implies that he generally does not measure his prices on the basis of an individual assessment of the financial instrument. Accordingly, market making is characterised by a certain degree of valuation indifference.
b. Risik Aversion
The market maker aims to ensure that purchases and sales correspond in volume over a certain period of time. However, in the course of his activities, his securities holdings are inevitably subject to fluctuations. To the extent that its holdings are higher or lower than its target holdings, it is exposed to market price risk. In general, market price risk can be defined as the risk arising from changes in the market price of a financial instrument over a period of time. However, the general market price risk is at least partially offset by diversification if market making is carried out in relation to several financial instruments. Price losses in one financial instrument are offset by price gains in another financial instrument. There remains, however, the risk arising from a movement in the overall market.
A more important risk category for market-making is the adverse selection risk. Economist Bagehot laid the theoretical foundation for this in 1971. Since market makers are continuously prepared to conclude transactions with other market participants, they are exposed to an increased risk of contracting with market participants who have value-determining information that is not yet reflected in the current market price. These can be insiders and arbitrageurs in particular. The latter exploit market inefficiencies, for example in cross-market arbitrage, by taking advantage of price differences in different markets. In such transactions, market makers always lose. They lose if the price falls after a purchase or rises after a sale.
To reduce the risks associated with market making, market makers generally aim for a balanced portfolio. In turn, they achieve this when the sum of all purchases equals the sum of all sales over a certain period of time. The target position can be positive if, for example, the market maker ensures his ability to deliver illiquid financial instruments. The target position can also be zero if the market maker is typically able to balance short positions until the end of each trading day. The quoting behaviour of the market maker is therefore also characterised by a certain degree of risk aversion.
c. Control of Holdings
Market makers have various possibilities to control their holdings of financial instruments. For example, they can vary the buy and sell volumes of the quotes. If the inventory is too high, more volume could be placed on the sell side. However, it is also conceivable that the market maker does not place a quote at all, but is only present on one side of the order book; if the inventory is too high, he would only place sell orders. However, the inventory can also be controlled in particular by setting the respective prices. If the inventory is too high, the market maker would lower the buy and sell prices. In this way, the market maker makes selling more likely because potential sellers can now buy more cheaply; he makes buying less likely because potential sellers obtain a lower price.
4. Market Maker Funktions in Securities Trading
Market makers (including specialists, designated sponsors etc.) make important contributions to the functioning of securities markets. In economic terms, they fulfil various functions by continuously being available as counterparties to other market participants. The provision of liquidity can be described as their main function. In addition, there are a variety of other functions.
a. Provision of Liquidity
Market makers continuously provide liquidity to the markets. That is their main function.
i. What is Liquidity?
Basically, liquidity refers to how easy or difficult it is to realise transaction interests without significantly affecting the price.
Four dimensions are attributed to the concept liquidity: market depth, market width, recoverability and immediacy.
Market depth refers to the ability to execute transactions close to current market prices and is based on the number of limit orders in the order book.
Market width represents a high volume of transaction interest close to current market prices.
Recoverability refers to the ability of a market to establish a new market equilibrium with sufficient market depth and width through new, balancing orders after temporary, non-information-related price changes.
Immediacy refers to the speed with which an order can be executed.
ii. Effect of the Market Maker on Liquidity
The activity of a market maker improves liquidity on all four dimensions:
It improves market depth by making more transaction prices available to potential counterparties.
It improves market breadth by making more transaction volume available to potential counterparties.
It improves recoverability by striving to always provide tradable prices.
Ultimately, it also improves immediacy by reducing the waiting time for potential counterparties to find transaction volume at a market-driven price.
iii. Economical Concepts for Liquidity Measurement
In economic research, various concepts have been developed that can be used to quantitatively determine the liquidity of a financial instrument. In detail, however, the methods are controversial. Economist O'Hara has described this vividly:
„Liquidity, like pornography, is easily recognized but not so easily defined.”
iv. Liquidity Measurement of Deutsche Börse AG
The liquidity measure of Deutsche Börse AG is of particular practical importance. It measures the Xetra Liquidity Measure (XLM) on the basis of market depth, market width and immediacy, as well as the average order book turnover. The consideration of the average order book turnover is based on the experience that financial instruments with a high order book turnover are typically more liquid.
The result of this liquidity measurement is particularly important for the Board of the Frankfurt Stock Exchange to determine which trading model it assigns a financial instrument to. A financial instrument that is liquid according to this measurement (category A) can also be traded without a designated sponsor in the trading model "continuous trading with intraday auctions".
Financial instruments with a lower liquidity (category B) are basically assigned to the trading model "continuous auction specialist model". However, they may also be traded in the trading model "continuous trading with intraday auctions" if at least one designated sponsor undertakes to continuously provide liquidity to the trading of this financial instrument.
v. Market Making Systems at Trading Venues
The liquidity of individual financial instruments is also relevant from a regulatory point of view. For example, trading venue operators operating an "order book trading system based on a continuous auction" are only required to set up a market making system within the meaning of Sect. 26c para. 2 sentence 1 BörsG if liquid financial instruments referred to in article 5 para. 1 Delegated Regulation (EU) 2017/578 or certain derivatives relating thereto are traded in this system.
Whether a liquid market exists for shares, for example, is determined by article 2 (1) no. 17 (b) MiFIR in conjunction with Article 1 of Delegated Regulation (EU) 2017/567. The free float, the daily average of transactions and the daily average of the turnover achieved are significant for determining liquidity. For legal purposes, an ambitious liquidity measurement, such as that carried out by Deutsche Börse AG, would not be suitable.
b. Sub-functions
The provision of liquidity by the market maker entails a variety of effects that can be described as sub-functions.
i. Limiting Volatility
Market making limits volatility. Volatility basically refers to price fluctuations within a certain period of time. These can be based in particular on temporary imbalances between supply and demand. Market maker reduce volatility by providing more tradable volume.
ii. Contributing to Financial Market Stability
The provision of liquidity by the market maker can also contribute to financial market stability. For example, the US regulatory authorities CFTC and SEC attribute the flash crash on the US financial market of 6 May 2010, among other things, to a massive decline in the liquidity of the financial instruments concerned. Providing liquidity even under tense market conditions reduces such risks.
iii. Increasing Information Efficiency
Market makers can also increase the information efficiency of current prices.
A market is said to be information efficient if information affecting the value of a financial instrument is immediately reflected in prices. It is assumed that the current price of a financial instrument also reflects its actual value if all price-determining information is distributed equally among all market participants. As a rule, however, the price-determining information is irregularly distributed, which is why the current price can deviate from the actual value.
In principle, market makers set their prices on the basis of good information. For example, if they quote prices for a foreign security, they always keep an eye on the prices on the more liquid foreign market and reflect those prices in their quotes. A better information basis can also result, for example, from an exclusive insight into the order book. For example, the specialist at the Frankfurt Stock Exchange (FWB) has an exclusive insight into the market situation in the respective order book.
Since the market maker quotes are basically based on a good information basis, the market maker contributes to the informative value of the current prices and at the same time protects against misinformation to a certain extent.
iv. Reducing Transaction Costs
In economic research, transaction costs are basically divided into explicit and implicit transaction costs. Explicit transaction costs include, in particular, transaction fees to be paid to the trading venue operator. Implicit transaction costs arise for liquidity takers who taek immediately available liquidity and therby accept a higher purchase price or a lower selling price. Market makers narrow the spread in the order book through their quotation and thereby reduce implicit transaction costs.
v. Creating Circulation Markets
In addition, market makers can also create a circulation market by creating transaction opportunities, especially for illiquid financial instruments, which would not be available without market maker liquidity. Within a quote-driven sytem, in which transactions are concluded exclusively with one market maker, the market maker also creates a circulation market for liquid financial instruments.
vi. Improving the Possibility of Risk Allocation
Furthermore, the provision of liquidity by a market maker also improves the ability of other market participants to allocate risk. Market price risks can be better shifted to those market participants who are willing to bear these risks.
vii. Increasing the Market Value of Instruments
Ultimately, the continuous provision of liquidity by market makers can increase the market value of a financial instrument. Investors have the opportunity to buy the respective financial instrument from and sell it to the market maker at any time. This reduces their risk of not finding a suitable counterparty at a price in line with the market situation. Investors include this circumstance in the valuation of the financial instrument.
5. Distinction from the Market Maker System
Market makers can also be distinguished from market maker systems (quote-driven system). The term "market maker system" refers to a trading model. Execution venue operators have various options for organising the interaction of the respective participants with each other or with the market maker. One possible form of interaction is the market maker system. This denotes a procedure in which the participants, as liquidity takers, can interact and conclude transactions exclusively with market makers. Trading in a market maker system is also referred to as quote-driven trading. Market makers act as exclusive liquidity providers in a market maker system. However, market makers can also provide liquidity to other market players within the framework of an order book system (order-driven system).
Market Maker FAQ
What is a Liquidity Provider?
What is a Market Making System?
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