What is Market Making, and How Does it Affect Liquidity?

Market making is a critical function in financial markets, primarily aimed at ensuring liquidity. Liquidity, the ability to quickly buy or sell assets without causing significant price changes, is essential for the smooth operation of markets. Market makers play a pivotal role in maintaining this liquidity, facilitating efficient trading, and stabilizing markets. This article delves into the concept of market making, the mechanisms behind it, and its impact on liquidity.

What is Market Making?

Do you remember the concept of order books? An order book shows all the buyers and sellers for a particular stock.

Imagine a situation where there are no buyers or sellers listed in the order book for a stock. No one has placed any orders to buy or sell that stock.

In this scenario, if you wanted to sell that stock, there wouldn’t be anyone available to buy it. As a result, there would be no active market for that stock.

In our previous article, we talked about the importance of having an active market. This is where a specific role becomes essential for keeping the market active and ensuring liquidity: the market maker.

A market maker is a person or company that consistently offers to buy (bid) and sell (ask) in the market. This ensures that if a trader wants to buy or sell a stock, there will always be someone ready to trade.

To become market makers, individuals or companies must register with the exchange. Once registered, they can buy and sell securities all day at lower commission rates.

Market makers focus on a few selected stocks and continuously buy and sell them. There are usually several market makers for each stock. This setup is good for both companies and investors because it ensures that there is always an active market.

So, why do people or companies become market makers? What benefits do they get from this role?

The main reason people or companies become market makers is to make profits. Market makers earn profits through the bid-ask spread—the difference between the buying price and the selling price. By buying at the lower bid price and selling at the higher ask price, market makers capture this spread as their revenue.

The Mechanisms of Market Making

Quoting Prices: Market makers provide bid and ask prices for assets they are willing to buy or sell. These quotes are constantly updated to reflect market conditions and maintain competitive pricing.

Order Matching: When a trader places an order, the market maker either fulfills it from their inventory or matches it with another order. This immediate execution helps maintain market fluidity.

Inventory Management: Market makers must carefully manage their inventory of assets. Holding too much of one asset can be risky, so they often use hedging strategies to mitigate potential losses.

Risk Management: Market makers face various risks, including price volatility and inventory risk. They employ sophisticated algorithms and risk management techniques to minimize these risks while maintaining liquidity.

Example:

Consider this example of an order book.

The goal of market makers is to purchase a product at the bid price and sell it at the ask price.

Let’s take this example with a bid price of $10 and an ask price of $11. Suppose a market maker buys 1000 shares at $10 and immediately places a sell order at $11. If they are able to sell the shares at $11, they would make a profit of $1 per share. In this case, with a thousand shares, they would earn $1000.

The market maker then repeats this process to continue making profits.

As a market maker, the ultimate objective is to maximize profits by engaging in the buying and selling process. In doing so, market makers effectively create and maintain a market for the particular stock.

However, being a market maker entails certain risks. For instance, if a market maker purchases 1000 shares at $10 with the intention of selling them at $11, there is a risk if a substantial seller enters the market and causes the price to decline, consequently altering the bid and ask prices. Let’s assume that the bid decreases to $7 and the ask drops to $8. In such a situation, if the market maker is compelled to sell the shares at $8 after buying them at $10, they would incur a loss of $2 per share. Considering the thousand shares, this would result in a loss of $2000.

Market makers willingly bear the risk associated with their role, understanding that despite occasional losses, they will continue to repeat the process of buying at the bid price and selling at the ask price. Through repeated transactions, they aim to accumulate significant profits over time, even though they may experience occasional losses along the way.

That is precisely what market makers do. The money they earn comes from the spread they create.

In previous discussions, we have gained an understanding of the spread, which represents the price difference between the bid and ask in a market.

By examining the order book, we can observe that the spread in this case is $1. This is calculated by taking the difference between the ask price of $11 and the bid price of $10, resulting in a $1 spread.

This is merely an illustrative example. In reality, spreads in stocks are not fixed at a dollar amount like the previous example.

Spreads tend to be much narrower, particularly for highly liquid stocks. Some stocks may have spreads as narrow as 1 cent, while others may have spreads of 10 cents or 50 cents. However, there are rare cases where spreads can be wider, exceeding a dollar or more, but such instances are infrequent.

Market makers generally prefer larger spreads as they have the potential to generate higher profits. With larger spreads, the market maker can capture a greater price difference between the bid and ask prices, resulting in increased profitability per trade.

This leads us to the concept of passive and aggressive market approaches.

What is a Passive and Aggressive Market Approach?

If you buy at the bid price, you’re taking a passive approach as a buyer. By placing a limit order to buy, even if there are no sellers at that price, you wait patiently for a seller to come into the market and sell to you.

Market makers also use this passive approach. They don’t buy right away. Instead, they place their orders and wait for a seller to agree to their price before they make the purchase.

Let’s consider the following example.

If you place a limit order to buy at $25.29 or below, you are being passive. This means your order won’t be filled right away since no one is selling at that price. You wait for a seller to come along.

On the other hand, if you place an order at $25.30 or above, you are being aggressive. This means you are buying the asset immediately at the current ask price, which is the lowest price someone is willing to sell for. In this case, you are acting as an aggressive buyer.

If you place a market order to buy, you are also being aggressive. This means you are willing to buy the asset at any available price, without setting a specific limit.

Conversely, if you want to sell a stock and place a sell order at $25.30, you are being passive. You are waiting for a buyer to come along and purchase the stock at your price. Even if you set a higher price than $25.30, you are still being passive.

If you place a limit order to sell at any price above $25.21, you are being passive. You wait for a buyer to agree to your price. The only time you become an aggressive seller is when you place a limit order to sell at $25.20 or lower because there are buyers ready to buy at that price, resulting in an immediate sale.

In every trade, there is usually one passive participant and one aggressive participant.

This brings us to the concepts of adding liquidity and providing liquidity to the market.

Providing Liquidity to the Market

We talked about the importance of market liquidity, which is something both companies and investors want. A liquid market means a lot of shares can be sold without changing the price too much.

So, when you are being passive, are you adding liquidity or taking it away from the market?

Think about this scenario:

If you want to buy 20,000 shares of a particular stock and place a passive order at $10, you add 20,000 shares to the 1,000 shares already available at that price. This means there will now be 21,000 shares available for purchase at $10.

Now, if a seller enters the market and sells 5,000 shares using a market order, their order will be filled at $10 because there are buyers for 21,000 shares at that price. The seller can sell all 5,000 shares at $10 without significantly affecting the stock price.

But, if you hadn’t placed your order for 20,000 shares at $10, it would be different. If the same seller wanted to sell 5,000 shares at the market price, there would only be 1,000 shares available at $10, 2,000 shares at $8, and 1,000 shares at $7. To sell all 5,000 shares, the seller would have to keep lowering the price, potentially down to $6, because there wouldn’t be enough passive buyers to take all the shares.

So, the absence of passive buyers and sellers decreases liquidity. More passive participants with open orders on both the bid and ask sides increase market liquidity. This liquidity allows the market to handle larger orders, like the 5,000 shares sell order, without causing significant price changes.

Whenever you place a passive order, you are adding liquidity to the market. When you place a market order (an aggressive order), you are taking liquidity away.

Market makers always aim to provide liquidity to the markets. However, they have been largely replaced by high-frequency traders.

It’s important to note that making profits through market making at a retail level is challenging due to high competition and automation. However, understanding market making is crucial as it forms the foundation of many trading strategies.

How Market Making Affects Liquidity?

1. Enhancing Market Depth

Market makers contribute to market depth by providing multiple bid and ask prices at different levels. This ensures that there are always buy and sell orders available, allowing traders to execute large orders without causing significant price swings. A deep market attracts more participants, further enhancing liquidity.

2. Reducing Bid-Ask Spreads

By continuously quoting competitive prices, market makers narrow the bid-ask spread. A narrower spread reduces the cost of trading for market participants, making the market more attractive and increasing trading volume. High liquidity markets typically exhibit lower bid-ask spreads, benefiting all traders.

3. Stabilizing Prices

Market makers help stabilize prices by absorbing temporary imbalances in supply and demand. When there is excessive selling pressure, market makers buy assets, and when there is excessive buying pressure, they sell assets. This activity prevents extreme price fluctuations and contributes to a more stable market environment.

4. Improving Execution Speed

With market makers providing continuous quotes, traders can execute orders almost instantaneously. This speed is crucial for high-frequency trading strategies and for traders who need to quickly enter or exit positions. Faster execution times increase overall market efficiency.

5. Supporting Market Confidence

The presence of market makers reassures participants that they can buy or sell assets at any time, fostering greater confidence in the market. This confidence can attract more participants, increasing overall market liquidity and promoting a healthier trading ecosystem.

Conclusion

Market making is essential for keeping financial markets liquid. By constantly providing buy and sell prices, market makers help ensure smooth transactions, narrow the bid-ask spread, stabilize prices, and boost market confidence. Their role is vital for the efficiency and stability of financial markets, benefiting everyone from individual traders to large institutional investors. However, market makers face challenges such as following regulations and relying on technology to do their job well. Overall, market makers are key to the health and activity of financial markets.