With stock exchange transactions taking place in the blink of an eye, market makers play a vital role in trading by being ready at any given moment of a trading day to buy or sell at publicly quoted prices, thereby linking sellers and buyers. These broker-dealer firms accept the risk of holding a predetermined number of shares in a chosen security, thereby facilitating instant trades in that security. Market makers trade in an environment of vigorous competition for customer order flow. As the term suggests, market makers create a market by displaying buy and sell quotations for a guaranteed number of shares. As a buy order enters the system, the market maker will sell from its own inventory, or in the event of not having inventory, will seek a corresponding sell order or inventory from other market makers. With modern technology at the forefront of stock market trading, these complex transactions take place in a matter of seconds.
Of course, it would be impossible for buy and sell orders to always correspond, which is why market makers hold inventory. However, holding inventory has a high risk element to it, and market makers need to be compensated for this risk. This is where bid/offer spread, a.k.a. buy/sell spread, comes into play, where the market maker pockets the difference between the immediate sale and purchase prices. These differences are generally very small, but with millions of shares trading every day, a market maker’s income would not be considered to be small change. Additionally, market makers operating in the realms of stock exchanges receive liquidity rebates from electronic communication networks (ECN) for every share sold to, or purchased from, each posted offer.
Foreign exchange firms are also considered to be market makers, as are many banks, being compensated by price differentials in the buy and sell process, as well as for providing liquidity, facilitating trade and reducing transaction costs. With more than 500 member firms acting as market makers willing to quote both buy and sell prices for an asset, Nasdaq is considered to be a model example of the value of market makers in stock market trading.
