Market Maker – How to Become a Maker of Markets

  • September 16, 2020

Are you a market maker? Whether you want to buy a car, groceries, stocks or Bullish Bears swag, you need two parties. A seller of the goods and a buyer of the goods, which in this case is you.

You also need a sale location: the grocery store for groceries, car dealership for cars, and the website for Bullish Bears swag.

To add further complexity, the buyer naturally wants to pay the least price, and the seller wants to get the best possible price for their product. Predictably, we end up having a spread in what both want for payment. 

What Is a Marker Maker?

  • A market maker is a company or person who controls the buy and sell aspect of stocks. The goal is to make a profit off of both the bid and the ask spread. You need two parties to make that happen. Plus the market maker. 

Think of it like this: you head into a car dealership willing to pay only $100,000, but you see a beautiful car listed at $240,000. You don't want to pay the extra $140,000, but it's an exotic car with only a few models made.

Predictably, the spread will stay large if there isn't a lot of inventory available, with little wiggle room to barter on price. Which means that the dealer will profit handsomely in the deal. 

However, if there are 20 other dealerships in the city selling the same car, you have a good chance of narrowing that spread down to a more reasonable price. In this case, with lots of inventory, the spread is less and the dealers profit is lower. 

And this is no different in the world of trading. Whether its stocks, options, exchange-traded funds (ETFs), they all need a market of buyers and sellers to move on the exchanges. And we also need a large supply of inventory, so you're not stuck with huge prices. 

But where does this liquid market come from? Two words: Market Makers

Market Maker

1. Making a Market

"Making a market" refers to the willingness to buy and sell the securities of a defined set of companies to broker-dealer firms of that specific exchange. 

For starters, each market maker displays buy and sell quotations for a guaranteed number of shares. Once the market maker gets an order from a buyer, they immediately sell off their position of shares from their personal inventory, completing the order. 

In short, market making makes it smoother and easier for us to buy and sell securities. Without it, it would be a long and painful process to buy and sell stocks. 

2. Who Are the Market Makers?

Market makers, also known as high-volume traders, literally "make a market" for securities. A market maker (MM) can be both a firm or an individual who actively quotes two-sided markets in certain securities. 

Very often, market makers are large brokerage firms that provide trading services for investors and traders alike. Not only do they profit dearly from their services, but they keep liquidity in the financial markets.

Even though a market maker can also be an individual trader, it's highly unlikely. For the most part, the size of securities needed to facilitate the volume of purchases and sales exceeds trader Joe reach. Because of this, the vast majority of market makers work on behalf of large institutions.

3. How to Become a Maker of Markets

Before we dive in, you need to understand the difference between Nasdaq Market Maker vs. NYSE Specialist. For starters, an NYSE Specialist is a type of market maker who works on the NYSE floor and specializes in trading specific stocks. 

Alternatively, the Nasdaq Marker Makers consists of large investment companies that buy and sell securities through an electronic network. They provide a competitive trading environment and efficient, low-cost execution of orders.

There are multiple market participants, including market makers, order-entry firms and electronic communications networks (ECNs) that utilize NASDAQ's trading services.

Who Are the Biggest Market Makers?

  • GTS is considered to be the biggest market maker on the Nasdaq. They serve many different stocks on international markets as well as US markets. In fact, they were the market maker who hosted the Pinterest stock IPO.

1. Market Maker and the Importance of Bid-Ask Spreads

To that end, market makers provide bids and offers (known as asks) and the market size of each. A bid-ask spread is a difference you can buy the units for at any given time or what you can sell them for on the market at that point in time.

Secondly, it represents the cost to the market maker if they were to buy or sell the entire underlying basket to compensate them for the risk of making that market. Let's make it clear upfront: Market makers profit on the bid-ask spread and benefit the market by adding liquidity.

Let's say we have a market maker in stock ABC who provides a quote of $10.00-$10.05, 100(buy) x 500(sell). This means that they will bid (will buy) 100 shares for $10.00 while also offering (will sell) 500 shares at $10.05. 

The other trader may then buy (lift the offer) from the market maker at $10.05 or sell to them (at the bid) at $10.00. As a result, market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.

2. What Is Liquidity?

In case you didn't know already, market makers produce liquidity. Liquidity is how easily you can get into and out of a stock position.

A stock is liquid if you can rapidly sell the shares with little impact on the stock's price. It is essential because it helps traders get in and out of stocks more cheaply.

3. How Market Makers Produces Liquidity in the ETF Market

Now that we understand liquidity, let's talk about market makers in the ETF field. ETF's are not like stocks in that there's a finite number of shares are available for sale on the market.

With an ETF, it's an open structure. To clarify, an ETF provider can issue new shares or redeem shares of that ETF based on the supply and demand in the market. 

That said, the way the ETF ecosystem works and how liquidity's provided to the market is that there are three levels of liquidity for an ETF. First is the natural level or the number of shares traded on the exchange.

Or, the number of units sold by A and bought by investor B. Hence, the more units traded, the higher the liquidity.

4. Second Level Liquidity

The second level of liquidity is where the market-making activity comes in to play. The market makers are the large institutions, typically, the big banks.

Now market makers are responsible for creating liquidity in the ETF market; they are responsible for posting bid/ask quotes (the number of shares available for sale or purchase) at a specific price.

Furthermore, they're responsible for keeping the ETF price in line with its net asset value. Now the third important layer of liquidity is the EFT provider. If there is a large buy order, the ETF provider delivers a creation unit of that ETF.

Typically, 50,000 shares of the ETF get delivered to the market maker, who then buys the ETF's underlying securities. They then offer those ETF units for sale and post a bid and an ask quote for that ETF.

That may occur, for example, if you are a pension fund, and you are buying ten million of a bond ETF. In reality, you will not buy that from other investors in the market and maybe not even from the market maker directly. The ETF providers will have to go out and create those new units and ad them into them to market. 

The average retail investor who's trading 5-6 k of an ETF doesn't need the market maker and ETF provider to create new ETF units.

Typically, it's only a considerable buy and sell order that exceeds the units' current quantity where you'll see this happening.

Can Market Makers Lose Money?

  • We're so used to having our money taken by market makers right? So can they lose money? Or is this one of the rare stock market jobs where you only make money? In short, market makers can lose money. The goal is to make money off both the bid and the ask. But if the trade closes at a worse price than it's opened at, the market maker loses money.

1. Key Takeaways

  • A market maker can be an individual market participant or a member firm of an exchange. What they do is buy and sell securities for their own account, display prices in their own exchange's trading system. Overall, their primary goal is to profit on the bid-ask spread.
  • Most often, we see brokerage houses as the most common type of market maker. Firms like this provide purchase and sale solutions for investors to keep financial markets liquid.
  • Market makers get paid for the risk of holding securities because their value may decline in the time they bought it from a seller and sold it to a buyer.

2. How a Market Maker Smooth the Markets

At the same time, market makers must continuously commit to quoting bid and ask prices for securities.

Furthermore, they must also commit to the volume they're willing to trade, and how long they will quote at the Best Bid and Best Offer (BBO) prices. 

Regardless of market conditions, market makers must stick to these parameters at all times. Even when markets become erratic or volatile, market makers must remain disciplined to continue facilitating smooth transactions.

3. How Does a Market Maker Make Money?

Market makers sometimes are the bag holders. They've bought assets from a seller and run the risk of seeing the value decline before they get a chance to sell it to a buyer.

Because of this, they get compensated for the risk of holding assets in the form of the bid-ask spread. 

Remember when I talked about this above? Well, let's say I decide to buy FB from my broker. On the screen, I see a bid price of $100 (what the broker paid for the stock) and an ask price of $100.05.

I go ahead and buy it for $100.05, and the market maker keeps the $0.05. Now, this doesn't seem like a large commission, but through high-volume trading, these small spreads add up fast; 6 figures fast, to be exact.

At this point, it's safe to say the wheels of the money-making machine are churning in your heard. I am starting to wonder how to become a maker of markets. 

Keep reading to find out how. 

4. The Registration Process of a Market Marker

A prospective market-making firm must already be or apply to be a NASDAQ member. Simultaneously, firms are permitted to be in a pending status when starting their connection process to the NASDAQ.

For information about membership requirements, please visit their membership page. If you are a NASDAQ member and don't yet have connectivity to the NASDAQ systems, you'll need to contact NASDAQ Subscriber Services at 212.231.5180.

You'll need to pick the right market participant identifier (MPID) and establish connectivity through one of the NASDAQ protocols.

However, all NASDAQ members who already have access to NASDAQ need to follow the steps outlined below:

Steps to Become a Market Maker

  1. Complete the Market Maker Registration Form (PDF) 
  2. Have your clearing agency call the National Securities Clearing Corporation (NSCC) to ensure a clearing arrangement.
  3. Contact the local FINRA District Office to express an interest in becoming a NASDAQ market maker.
  4. Compile all information, and send it to the local FINRA District Office for review to see if you are qualified to be a NASDAQ market maker.)
  5. The FINRA District Office will forward an approval form to NASDAQ's Subscriber Services department. (If your firm is not a FINRA member, the approval will be made by The NASDAQ Stock Market LLC.)
  6. A NASDAQ Subscriber Services representative will notify you if you are permitted to make markets and will activate all your services

1. Responsibilities of the Nasdaq Market Maker

  • Enter, retrieve, monitor and adjust quotations in response to changing market conditions.
  • Enter and execute orders in all of the NASDAQ's systems.
  • Utilize automated services to compare and clear NASDAQ 
  • Register the number of securities approved by the firm's local FINRA District Office. In case you didn't know, FINRA provides regulatory services for all NASDAQ members on behalf of The NASDAQ Stock Market LLC.

2. Market Makers Are Legislated

Depending on the market makers jurisdiction, they have to operate under a given exchange's bylaws. Each exchange is approved by a country's securities regulator, such as the Securities and Exchange Commission in the U.S. 

Another key point to realize is that rights and responsibilities vary by the exchange and the type of security you're trading. 

3. Word of Caution

In some cases, a market maker is also a broker. Unfortunately, this can create an incentive for a broker to recommend securities for which the firm also makes a market.

As a trader, do your due diligence; make sure that there is a clear separation between your broker and the market maker.

Final Thoughts

If you're interested in becoming a market maker, you can check out the list of requirements to make that happen for you.

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