Market Maker Importance in the market
A market maker is a person or brokerage house appointed by the stock exchange who is always prepared to buy and sell securities in order to provide liquidity to the markets.
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Example: Let’s take an example to understand what a market maker does
What if you were in desperate need of cash and want to sell your vehicle. You put an ad out no your local buy and sell website. But there is no one who is willing to match the price you want to sell the car for. A Market Maker (Vehicle dealer in this case), on the other hand, is a person or an institution that is ready to buy your vehicle. Sure, their bid for the car will certainly be lower compared to your asking price. But you will be getting someone to buy your vehicle and provide you cash.
Advantages and Disadvantages to the deal
The advantage is that you are able to readily convert your hard asset into cash through a market maker. The disadvantage is that you won’t quite get the price you are expecting. Now it is up to you whether you want to wait until your quoted price matches with the buyer price or you are willing to take a hit and opt for getting bit lower cash. In the financial markets, a market maker plays a similar role. They facilitate a smooth flow of the financial markets.
By holding a very large number of a given security, a market maker is able to satisfy a high volume of market orders in a matter of seconds at competitive prices. If investors are selling, market makers are supposed to keep buying, and vice versa. They are supposed to take the opposite side of whatever trades are being conducted at any given point in time.
How do Market Makers make money?
Without market makers, there would likely be little liquidity. In other words, investors who want to sell securities would be unable to unwind their positions due to a lack of buyers in the market.
If the market maker buys security, there is a risk that the price of that security may go south. In other words, buying security brings risk in their trading books. To compensate that risk, market makers charge a fee.
The fee can be in the form of commissions or generally the spread. Mutual fund houses, Investment firms are charged a fee whereas regular participants, there is a spread that they pay to the market maker. Market makers make money through the transactions they do and the spreads or commissions they earn.
Consider an example where the market maker may purchase your shares of Reliance from you for 2000 each (the ask price) and then offer to sell them to a buyer at 2000.75 (the bid price). The difference between bid and ask price is only 0.75, but by trading millions of shares a day, they managed to pocket a significant chunk of change to offset their risk.
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Importance of market maker
In contrast to conventional brokers, marker makers assume a high level of risk because of the high number of units they hold. Financial markets need to operate smoothly. Investors and traders prefer to buy and sell easily. Without market makers, there would likely be fewer transactions and the overall markets would slow down. This, in turn, would reduce the amount of money available to companies. Despite playing an important role, algorithmic or high-frequency trading has been eating into the share of traditional market makers.
Market makers and Brokers are not the same
Brokers are typically individuals who operate in the best interests of their clients and facilitate the sale of an asset to a buyer or seller. Market makers are typically large investment firms or financial institutions that create liquidity in the market.
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