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Author: StJohn Piano
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Summary: Market makers are high-volume traders (often large institutions) that "make a market" for assets by always being ready to buy or sell. Their activity makes the market more liquid. They make a profit on the bid-ask spread that they offer.

Relevant: Markets and States




Detailed explanation:

- A market is a place where buyers and sellers meet to trade a particular asset.

- The liquidity of a market means "how easy is it to buy/sell this asset without greatly changing its market price?". Very easy == very liquid.

- A market maker is a market participant that undertakes to always be ready to trade a certain volume of the asset at the market price.

- Market makers help keep the market functioning. If you want to sell an asset, they are there to buy it. Similarly, if you want to buy an asset, they will be ready to sell it to you.

- If the market maker were not present, providing an immediate counterparty for lots of trades, sellers and buyers might take a long time to find a match (in both price and volume) and successfully trade with each other.

- Market makers help to make the market more liquid. They increase the speed at which trades can occur, and the number of trades overall.

- Market makers take on a certain level of risk. During their operations, they will hold a particular volume of the asset in the market. There is a chance that the price might decrease rapidly while they hold the asset, and their losses could be quite large. [0] Their compensation for this risk is that they make a profit from the spread.

- The spread is the difference between the bid price and ask price that the market maker offers to the market. The market maker will set an ask price, at which it promises to sell the asset (up to a certain volume) to any buyer. It will also set a bid price, at which it promises to buy from any seller (up to a certain volume). The ask price is necessarily higher than the bid price. The difference between the two prices is the market maker's profit on a trade (really a pair of trades, one with a buyer and one with a seller). These bid and ask prices do not have to be exactly the same as the market bid / ask prices. Also, the promised bid and ask volumes do not have to be identical.

- Note: A market participant who wishes to make an immediate trade will buy at the ask price and sell at the buy price. Their counterparty (often a market maker) is necessarily selling at the ask price and buying at the bid price i.e. the other way around.

- The market maker makes a small profit from the spread, but aims to make a lot of trades. It's a high-volume business.

- The market maker will often have a closer relationship with the market owner than most market participants do. The market owner will set the minimum asset volume that the market maker must provide. The market owner may also put conditions on how greatly the market maker's bid / ask prices can vary from the market bid / ask prices. In return, the market owner may grant various advantages to the market maker. Example advantages: Monthly payment, reduced transaction fees, informational access.

- There may be multiple market makers in a particular market.

- Market-maker spreads widen during volatile market periods because of the increased risk of loss. They also widen for assets that have a low trading volume or low liquidity.




I already knew some of this information, but did a fair amount of reading to fill out the rest of it. For a list of links to the material I used, please see this footnote: [1]




A useful excerpt from "The race to zero" (page 5), by Andrew G Haldane:

Frictions in pricing arise from the process of matching buyers and sellers. Here, the role of market-makers is key. The market-maker faces two types of problem. One is an inventory-management problem - how much stock to hold and at what price to buy and sell. The market-maker earns a bid-ask spread in return for solving this problem since they bear the risk that their inventory loses value.

Market-makers face a second, information-management problem. This arises from the possibility of trading with someone better informed about true prices than themselves - an adverse selection risk. Again, the market-maker earns a bid-ask spread to protect against this informational risk.

The bid-ask spread, then, is the market-makers' insurance premium. It provides protection against risks from a depreciating or mis-priced inventory. As such, it also proxies the "liquidity" of the market - that is, its ability to absorb buy and sell orders and execute them without an impact on price. A wider bid-ask spread implies greater risk in the sense of the market's ability to absorb volume without affecting prices.





An interesting point made in:
www.investopedia.com/terms/b/bid-askspread.asp

The bid-ask spread is the de facto measure of market liquidity.





Summary: Market makers are high-volume traders (often large institutions) that "make a market" for assets by always being ready to buy or sell. Their activity makes the market more liquid. They make a profit on the bid-ask spread that they offer.




Further reading:

Lombard Street by Walter Bagehot: Chapter 1

The two currencies of Florence by Raymond de Roover