Did you know that stock exchanges try to improve liquidity and trading volume at times? They do so to attract more investors and provide the required securities. Stock exchanges depend on market makers to ensure a continuous flow of shares to investors. Without their presence, we might not have access to stocks, derivatives, and other securities at all times. Read on to understand what is a market maker in detail.
What is a Market Maker?
Market Makers are the individuals or entities that play a crucial role in boosting market liquidity and trading volume. They work within a larger company or entity and are authorized by stock exchanges to enhance market conditions. Their primary goal is to improve liquidity and trading volume, following specific regulations set by the authorities.
Their absence could lead to challenges for buyers and sellers in finding desired assets promptly. They ensure the availability of stocks, derivatives, and other assets as needed, setting quotes for buy and sell orders. Maintaining liquidity involves buying or selling assets, offering bid and ask prices to traders, and profiting from the price differences.
How Market Makers Earn Profits?
Market makers themselves hold securities to facilitate the activities in the stock market . Since the price of securities might go down any time, these makers are at risk. To compensate for the risk of holding securities, they are asked to provide a two-way quote for securities. The two-way quotes act as a commission for them.
For instance, you might find that the bid price of a stock is Rs 200, while the ask price is Rs 200.10. It means that you will purchase the stock at the rate of Rs 200 but sell it at Rs 200.10. This bid-ask spread allows them to earn profits. While the bid-ask spread might be small for an individual security, it adds up to a substantial total for all securities in the market.
How Do Market Makers Work?
Market makers involved in enhancing trading volume and liquidity by buying or selling securities follow specialised rules before engaging in activities. They typically focus on stocks but deal with various asset types. They can be employed by brokerage firms, stock exchanges and trading platforms Their actions are governed by specific regulations to prevent illegal practices that manipulate market liquidity or trading volume. They provide bids and ask prices while holding some securities themselves.
Real-life examples illustrate how they operate. Retail brokerage firms, assisting public investors, often utilize market makers to enhance stock and securities liquidity. Institutional entities focus on improving the liquidity of mutual funds, pension funds, and other collective investment schemes. Some use trading algorithms for quick succession orders, known as wholesale market makers. Despite their differences, the primary goal remains consistent – enhancing asset liquidity for public investors.
Factors to Consider
Now that you understand the market maker’s meaning, let us discuss a few important factors. You already know that they are responsible for improving liquidity and trading volume in the market. Trading volume is the total number of orders executed in the market. On the other hand, liquidity represents the ease of buying and selling securities for investors. One can say that higher trading volume leads to increased liquidity in the market.
Another factor to consider is the order execution time. Since they ensure the availability of securities in the market, they decrease the order execution time for investors. When abundant securities are available in the market, the order execution time for individual investors will automatically decrease. Stock exchanges, brokerage firms, AMCs, and other players depend on them to improve the overall trading scenario.
Role of a Market Maker in the Market
As discussed above, the primary role of a market maker is to boost liquidity and trading volume in the market. They are required to provide buy and sell quotes (bid-ask spreads) to facilitate investors. They ensure that the gap between the bid and ask prices is minimal, thus allowing better rates for investors.
Market makers often have to hold securities to improve the liquidity and trading volume. Since they are at risk by holding securities, they are allowed to earn from bid-ask spreads. The difference between the bid and ask prices is the profit for them. There is always a risk of non-execution on both sides of an order. When both sides of an order cannot be executed, they might not make a profit.
How Do Market Makers Impact Liquidity?
They have a crucial role in improving the overall liquidity in the market. Besides improving liquidity, they also create a safe space for trading. When they provide two-way quotes, they reduce the chances of basis risk in the market. Also, they ensure the availability of securities by providing two-way quotes.
For instance, they will create volumes of stocks for public investors. It prevents the market from becoming illiquid at any stage. They often hold stocks themselves to improve the liquidity in the market. The Bombay Stock Exchange (BSE), the National Stock Exchange (NSE), and many other players have employed them to improve liquidity.
In a Nutshell
Market makers are crucial for the entire trading ecosystem. They improve the liquidity and trading volume, thus attracting more investors. They are important to stock exchanges, brokerage firms, AMCs, and other players. They are also responsible for providing two-way quotes (bid and ask prices) for different securities. The difference between the bid and ask price (bid-ask spread) allows them to earn profits. They often hold securities themselves to execute orders from individual investors. Learn more about market makers now!