A market maker (also called a liquidity provider) is a firm or individual that quotes both a buy and a sell price for a financial instrument and stands ready to trade at those quotes, profiting on the difference between the prices, known as the bid–ask spread. By committing capital to hold inventory and continuously posting quotes, market makers supply market liquidity, enabling other participants to transact on demand and contributing to price discovery.

Market makers operate across stock exchanges, over-the-counter markets, and electronic trading venues, taking various institutional forms: designated specialists at the New York Stock Exchange, competing market makers at Nasdaq, official market makers on the London Stock Exchange under the SEAQ system, and "designated sponsors" at German exchanges.

In decentralized markets such as cryptocurrency protocols, the role of the traditional market maker is performed by automated market maker algorithms and pooled-liquidity contracts; participants who deposit assets to such pools earn fees from trades that execute against them. Market making in both traditional and decentralized venues has been the subject of post-2008 regulation aimed at separating intermediation from proprietary trading within deposit-taking banks. Theoretical study of market making advanced in parallel: a foundational 1985 paper by Lawrence Glosten and Paul Milgrom showed that, in a market where some traders may hold private information, the equilibrium bid–ask spread compensates the market maker for the adverse selection risk of trading with informed counterparties.

Mechanics

A market maker quotes a bid (the price at which it will buy) and an ask or offer (the price at which it will sell) for a given quantity of a financial instrument. The spread between bid and ask is the principal source of market-maker revenue: if buy and sell orders arrive in equal volume and the mid-price does not move, the firm earns the full spread on each pair of round-trip trades.

In equity markets

United States

On the New York Stock Exchange and the NYSE American, designated market makers (DMMs), previously known as "specialists", act as the official market maker for each listed security, supplying a defined level of liquidity and taking the other side of trades when short-term order imbalances appear. In return, they receive informational and execution privileges set by exchange rules.

Listed United States market-making firms include Citadel Securities, Virtu Financial, Jane Street Capital, Optiver, IMC, and Flow Traders, several of which appear on the European Securities and Markets Authority list of authorised market makers under Regulation (EU) No 236/2012.

United Kingdom

On the London Stock Exchange, member firms that take on a quoting obligation become official market makers for a security. Their two-sided quotes appear on the Stock Exchange Automated Quotation system and are visible to brokers acting on behalf of clients. Each stock has at least two official market makers, who are obliged to deal at their displayed prices.

Japan

The Tokyo Stock Exchange introduced an ETF Market Making Incentive Scheme in 2018, which provides fee rebates and other incentives to firms that maintain qualifying quotes in eligible exchange-traded funds. Listed scheme participants have included Nomura Securities, Flow Traders, and Optiver.

In foreign exchange and derivatives

Most foreign-exchange dealing firms and many banks act as market makers, quoting two-sided prices in currency pairs and earning the spread on client trades.

Because decentralized exchanges have no central operator with jurisdictional reach, government enforcement of trading or disclosure rules against AMM protocols has been a recurring policy challenge.

Regulation

Following the 2007–2008 financial crisis, regulators sought to separate intermediation activity from proprietary risk-taking within deposit-taking banks. In the United States, the Volcker Rule (section 619 of the Dodd–Frank Wall Street Reform and Consumer Protection Act) restricts insured depository institutions from short-term proprietary trading but preserves explicit exemptions for market making, underwriting, and risk-mitigating hedging. In the United Kingdom, the Independent Commission on Banking, chaired by Sir John Vickers, recommended a structural ring-fence under which market-making and other investment-banking activities sit outside the retail-banking perimeter at large UK banks; the recommendation was implemented through the Financial Services (Banking Reform) Act 2013.

In the European Union, short-selling and market-making activity is governed by Regulation (EU) No 236/2012, under which firms must notify the relevant competent authority before relying on the market-making exemption from short-selling restrictions, and the European Securities and Markets Authority maintains a public register of authorised market makers and primary dealers.

See also

  • Automated market maker
  • Bid–ask spread
  • Market liquidity
  • Market microstructure
  • Sales and trading
  • Stockjobber

References

  • Understanding Derivatives: Markets and Infrastructure – Chapter 1 Federal Reserve Bank of Chicago