Make a Market (Securities Trading) - Explained
What is Making a Market?
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What is Make A Market?
Make a market is a procedure whereby a person or brokerage house is ready, willing and able to buy or sell securities at quoted bids and ask prices in order to provide liquidity to the markets. From a brokers point of view, having the capability to make a market allows it to service buy or sell orders of its customers straight out from its inventory, instead of having to source stocks from other brokerages or investors. This makes it quicker and easier to service customer orders even when high trade volumes are involved. However, brokerage firms that also act as market makers are required by legislation to detach their market making activities from their brokerage sales operations, in order to ensure impartiality for the benefit of the investors.
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How Does Making A Market Work?
Market makers, also known as liquidity providers, are market participants (typically member firms of an exchange) that hold disproportionately large amounts of any given financial instrument or commodity, so that they can successfully and efficiently service a high volume of market orders in very short time and at competitive (publicly quoted) prices. Market makers typically display their buying and selling prices of securities in the exchanges trading system. The transaction that involves a brokerage house buying securities on the secondary market for its own account is known as a principal trade. Similarly, an agency trade is a buy or sell transaction that the brokerage house initiates on behalf of its customers. Market makers are indispensable to any exchange since they facilitate the circulation of securities, thus providing liquidity, while also ensuring efficient trading. Market makers are governed by statutes laid down by their corresponding stock exchanges and approved by securities regulators such as theSecurities and Exchange Commission(SEC) in the United States, for example. However, different market makers have different rights and responsibilities that are determined by the respective securities exchanges that they are affiliated to as well as the markets that they specialize in. Unlike conventional traders and investors that usually draw profits from the rise or fall of a security's price, market makers derive their income from the market maker spread (also referred to as the bid-ask spread), which is the difference between the prices at which they are willing to buy and sell the security via two-way quotes. As such, a market maker will have to either buy or sell securities, based on the kind of trades that are placed by the investors, irrespective of the direction in which the price of the security is moving. It is important to note here that a market maker will typically take the opposite side of whatever trade is being placed at any given point of time if investors are selling a particular security, the market maker will be required to keep buying, and vice versa.
Scope of Market Makers
Market makers are widely prevalent in stock exchanges across the globe for example, in the U.S, stock exchanges such as the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) have officially designated market makers, formerly referred to as specialists. On the other hand, other prominent stock exchanges such as Nasdaq have provisions for allowing several competing market makers for the same security at the same time. Similarly, in the United Kingdom, the London Stock Exchange (LSE) allows for official market makers for various securities. These market makers typically display their prices on the Stock Exchange Automated Quotation (SEAQ) system. Lastly, in Germany, the Frankfurt Stock Exchange (FWB) provides for market makers, known as designated sponsors, to be appointed by the listed companies. The role of market makers is not restricted to the securities exchanges alone. Market makers are also operational in currency exchanges in the form of foreign exchange trading firms and banks.