Written by Vibhav Das
Imagine you are looking to buy a share of Walmart (WMT) at the current market price. You go on your trading platform of choice and submit a market order, and within seconds your transaction is executed. But who sold you that security? Was it another person who just happened to put in a sell order for one share of their WMT stock at that price? Or could it be an institution unwinding its millions-strong position?
While the above two scenarios are possible, they are quite unlikely. The counterparty to your buy order was a market maker.
Market makers are trading firms that continuously quote both the bid and ask prices for whatever securities they trade, and the differential between the bid and ask price is what they count as profit. For example, let’s say that stock XYZ has a bid price of $3.50 and an ask price of $4.00. This means that a trader, or price taker, would have to pay $4 to receive one share of XYZ and would receive $3.50 if selling the same share. Market makers are the counterparties to the above trades: they sell XYZ at $4.00 and offer $3.50 to purchase a share. By providing liquidity to the markets, they effectively are able to arbitrage profits by capturing the spread on every trade. Fifty cents may not seem like much, but considering that the average daily trading volume for most tickers in the S&P 500 is in the eight-figure range, it makes sense that profits start to add up.
While the above example showcases a spread of 50 cents, most spreads are quite tight, averaging anywhere from one cent to 20 cents. The reason for this is that there are multiple market makers trading any given security, so those that quote smaller spreads are more likely to find retail or institutional investors to trade with them vs. the firms that quote larger spreads. However, in illiquid securities, “the lead market maker may be the only buyer and seller around… [so] retail investors may have to pay a premium to buy shares and sell their investments at a discount” (Dion, 2009). Competition between market makers helps keep markets efficient and transaction costs low, ensuring that security prices remain largely continuous.
A few examples of well-known market makers are Citadel Securities, Akuna Capital, IMC Traders, and Flow Traders.
An important aspect of market makers is that they do not have an opinion on market directions. This implies that whenever a market maker’s bid/ask quote is executed, the firm must find a similar security to sell/buy in order to hedge its exposure taken on by the initial trade. This can be tricky – especially with exotic derivatives or currency trades, where like-for-like instruments aren’t always present.
Up to now, it seems as though market makers practically run a riskless endeavor, save for minor difficulties in properly hedging. However, market makers face many risks to their operations. For one, the algorithms underpinning their strategies require constant maintenance and can cause severe mayhem if not supervised properly. Look no further than Knight Capital, a now-defunct market maker that lost more than $460 million in 30 minutes in 2012 after an engineer mistakenly executed a script with faulty code (Tabbaa, 2018). The script’s code was intended for a testing environment, not a trading environment, and was created to verify the proper behavior of other Knight Capital algorithms. Another unseemly risk market makers take on is inventory management. While market makers are generally hedged, there are certain times when they find themselves holding “naked” positions. These positions are especially risky for market makers, as they are unprotected and could prove disastrous for the firms if the market moves against them. During the pandemic sell-off in early 2020, many market-making firms were blown out when certain positions, mostly tied to esoteric derivatives plays, dramatically fell in value and pushed them into insolvency. Although the risks market makers assume are many, most market makers are quite successful at mitigating them to ensure their liquidity provisions are largely unhindered.
Hopefully, it is clear that market makers are important for a properly functioning market since they serve as the backbone for all price takers. If market makers did not exist, imagine how much worse the financial crisis – or even the drastic pullback seen in March – would have been: everyone rushing to sell any and all assets in efforts to shore up cash, but no one willing to take on positions. This would lead to an illiquid market with extremely large bid-ask spreads, severely restricting the ability for people to unload their positions. Enter market makers, and there is an assurance that at any given time, for any given security, there will be a party willing to transact on both sides of the market.
Works Cited
Tabbaa, B. (2019, September 08). The Rise and Fall of Knight Capital – Buy High, Sell Low. Rinse and Repeat. Retrieved from https://medium.com/dataseries/the-rise-and-fall-of-knight-capital-buy-high-sell-low-rinse-and-repeat-ae17fae780f6
Dion, D. (2009, August 10). How Market Makers Profit on ETFs. Retrieved from https://www.thestreet.com/investing/etfs/how-market-makers-profit-on-etfs-10568719