What is a Market Maker?

Market makers are key players in financial markets who provide liquidity and act as intermediaries between buyers and sellers. By continuously offering buy and sell prices, they ensure that investors can trade whenever they wish, helping markets function efficiently.

Market makers typically consist of large banks, brokerage firms, and financial institutions. Due to their role in providing liquidity, they hold a position, especially in stock, forex, and bond markets. Their presence helps investors execute trades more quickly and efficiently.

In this article, we take a closer look at the roles of market makers.

Understanding the Role of Market Makers in Forex Trading

When it comes to Forex, the role of market makers is to provide liquidity by setting the spread. They continuously offer bid and ask prices for currency pairs, creating a regular flow of pricing in the market.

The Forex market is the largest and most liquid financial market in the world. However, for this massive market to function effectively, market makers must constantly provide price quotes for currency pairs. This allows traders to execute trades at any time and take positions as they wish.

The main roles of market makers in Forex trading are as follows:

• They offer continuous bid and ask prices, allowing traders to execute trades at any time. This liquidity ensures the market operates smoothly.
• Market makers determine the spread. The spread represents the trading cost for investors.
• Maintaining balance in the market by providing price quotes even during periods of volatility, market makers ensure continuous trading.
• While managing their own portfolios and trades, they also take on the positions of traders, providing liquidity and managing market risks.
• By constantly trading, market makers determine the prices of currency pairs and reveal prices that reflect the supply and demand balance in the market.
• They directly fulfill buy and sell orders from traders, ensuring that transactions are completed smoothly.

How Do Market Makers Work?

To better understand how market makers operate, let's take a look at the following steps:

• Market makers regularly update both buying and selling prices for assets (for example, a currency pair). For instance, in the EUR/USD pair, a market maker may offer to buy at 1.1000 and sell at 1.1005.
• Whenever buyers or sellers wish to execute a trade, market makers facilitate these transactions, creating a fast and efficient trading environment. If a trader wants to take a large position, the market maker immediately matches the trade, eliminating delays and liquidity issues.
• Market makers profit from the spread between the bid and ask prices they offer. For example, they may buy an asset at 1.1000 and sell it at 1.1005. When investors sell to the market maker, they buy at a lower price, and when investors buy from the market maker, they sell at a higher price.
• When they purchase a currency pair, the market maker may incur a loss if the asset's price declines. Therefore, they continuously balance their portfolios and minimize risks through various risk management strategies. For instance, they may offset trades in different markets to protect themselves.
• During periods of volatility or high demand for a specific asset, market makers meet these demands and prevent extreme price fluctuations.

How Do Market Makers Make Money?

Market makers primarily make money from the spread, which is the difference between the bid and ask prices. They sell assets to buyers at a higher price and buy from sellers at a lower price.

Let's elaborate on the example: In a currency pair, the bid price might be 1.1000, and the ask price could be 1.1005. When investors buy, the market maker sells at 1.1005, and when they sell, the market maker buys at 1.1000. This price difference is the market maker's profit.

Additionally, due to the high trading volume, market makers continuously provide liquidity. The small profits earned from these transactions can add up to profits over time. In some cases, market makers can also take advantage of arbitrage opportunities, profiting from price discrepancies across different markets.

Market Maker Examples

To understand how market makers operate, let’s examine the following examples:

Citadel Securities is one of the largest market makers globally. During the 2020 COVID-19 pandemic, when markets experienced major volatility and liquidity challenges, Citadel Securities provided substantial liquidity to the U.S. stock market. Despite the high volatility, the firm continued to offer bid and ask prices, ensuring that market transactions could proceed without disruption. 

Especially during a period when retail investors showed significant interest, Citadel Securities managed trading volumes and played a role in balancing market liquidity and reducing volatility.

Goldman Sachs is another major market maker that operates globally. During the 2008 financial crisis, when the markets saw a downturn, the firm provided liquidity to both the stock and bond markets. 

While many financial institutions faced liquidity shortages during the crisis, Goldman Sachs maintained high trading volumes in both stocks and bonds, contributing to the smooth functioning of the markets. By continuously offering buy and sell quotes, the company helped alleviate the liquidity issues faced by the markets during the crisis.

What Entities Act as Market Makers?

Banks and financial institutions often act as market makers in markets such as forex and equities. Large banks, in particular, serve as a source of liquidity in the forex market, facilitating transactions for both individual and institutional investors.

Brokerage firms also play a role as liquidity providers in stock trading. They fulfill buy and sell orders from investors, contributing to the smooth and efficient execution of trades.

Exchange members are institutions or individuals authorized to conduct trading activities on a specific exchange. Typically, brokerage firms, banks, and investment firms are exchange members. These entities carry out buy and sell transactions on behalf of investors looking to trade on the exchange. By providing regular price quotes for specific stocks, they assume the role of market makers, ensuring that investors can execute trades at any time.

Market Maker vs Broker

Brokers are intermediaries that execute buy and sell transactions on behalf of investors. They provide services to investors by executing trades based on the prices offered by market makers and usually charge a commission per transaction. Unlike market makers, brokers do not take the opposite side of the trades; they simply facilitate the execution.

You can see the differences between market makers and brokers more clearly in the table below:

Market Makers vs Designated Market Makers

Designated market makers are appointed by exchanges and are responsible for ensuring continuous liquidity for specific stocks. Their importance lies in keeping the market moving, especially for assets with limited liquidity.

You can see the differences between the two types of market makers below:

What are the Risks for Market Makers?

• Sudden price fluctuations can lead to a decrease in the value of their positions, causing them to incur losses.
• When there is insufficient liquidity in the market, market makers may struggle to handle large trades.
• In cases of low liquidity, market makers may face challenges in handling large trades, forcing them to cover losses from open positions.
• Competition with other market makers can lead to tighter spreads, which reduces profit margins.
• Algorithmic trading and high-frequency trading firms can pose technological risks for market makers. Rapid price movements may put manual market makers at a disadvantage.
• Market makers are required to comply with regulations. Failure to do so may result in penalties and sanctions.

FAQ

Can retail traders act as market makers?

Retail traders cannot act as market makers. Market making requires big capital and technological infrastructure, and these activities are typically conducted by large banks, brokerage firms, and institutional investors.

How are market makers' profit margins determined?

Market makers' profit margins are determined by the spread between the bid (buy) and ask (sell) prices. They make money by facilitating transactions and capturing the difference between these prices. The wider the spread, the higher the profit margin. However, market conditions, competition levels, and liquidity can all influence the width of the spread.

How do market makers affect spreads?

Market makers influence the spread by setting the bid and ask prices in the markets. When liquidity is abundant, the spread can be narrower because market makers can quickly match trades. However, in times of low liquidity and high volatility, the spread may widen, increasing costs. The liquidity provided by market makers plays a key role in determining the spread.