Market Makers: Who Provides the Price When No One Else Will

A market maker names a price it will buy at and a price it will sell at, both at once, and it deals at either on its own money. When a holder sells and no other buyer has turned up, the market maker is the party that takes the shares onto its own book and carries them. The market maker earns the gap between its two prices, not a commission on the trade.

Start where the awkwardness actually is. A trade needs two willing parties in the same place at the same instant, and the instants almost never line up. Somebody wants to sell 8,000 shares of Suvarna Commercial Bank Limited, an invented bank, at three o'clock on a Tuesday afternoon. A stranger has no particular reason to want exactly 8,000 shares of it at three o'clock on the same Tuesday. And yet the sale usually goes through in a second or two, at a price sitting right where the screen said it would.

Somebody stood in the gap. Who that somebody is, what they take on by standing there, and how they are paid for standing there are the three questions that follow.

What has to be true before a trade can happen at all?

Two things, and only the second is interesting. The first is that a buyer and a seller agree a price. The second is that they both exist at the same moment. Every market solves the second problem in one of two ways: either it makes everybody wait until a natural other side arrives, or it pays somebody to be the other side in the meantime.

Here is the everyday version, and it is not an analogy so much as the same thing in smaller clothes. Think of the shop near a railway station that buys old phones and sells refurbished ones. A student walks in on a Wednesday wanting to sell a phone. There is no customer in the shop who wants that exact phone. The shop buys it anyway, puts it on the shelf, and waits. The phone might sit there for two days or for two months. While it sits, the shop's money is inside it, and the shop carries whatever happens to what a used phone of that model is worth. The shop is not arranging a sale between the student and a future buyer; it is being the buyer, and then later being the seller, and the two prices it uses are not the same number.

Change three nouns and the whole of this guide still holds. Once two orders meet on Kaveri Stock Exchange Limited, an invented venue, the trade is matchedThe moment a buy order and a sell order meet on a trading venue and become a trade rather than two separate instructions waiting. How an order gets there is covered separately. and everything that follows is plumbing. The step before the match is the harder one: whether there was anybody there to be matched against.

What exactly is a market maker showing?

Two numbers, shown together, and each of them is a promise to deal rather than an opinion about value. One is the price at which it will buy from a client. The other, always the higher of the two, is the price at which it will sell to a client. Both are good for a stated size, and both are live: either one can be hit and the deal happens.

The market maker is not arranging a trade between two other people; it is offering to be one of the two people. Nothing else in the plumbing works that way, and everything about how a market maker is paid, what it risks and when it walks away follows from that one fact.

The phone shop had to name both prices before it knew which way the student was going to go. The whole point of standing there is that either direction is fine. The shop could not wait to find out which one it would be. So it names a buying price it can live with and a selling price it can live with, and it accepts that on any given Wednesday it might do one, the other, or both.

For the shares in the worked example, the two prices are these. The market maker will buy at Rs 104.80/-. The same market maker will sell at Rs 105.20/-. The gap between the two is Rs 0.40/- a share. The number sitting exactly halfway between them, Rs 105.00/-, is Suvarna Commercial Bank Limited's own reported share price. Every other rupee figure here was chosen to make a point.

Who ends up holding the shares when nobody else wants them?

The market maker does. The answer sounds like an accounting detail. In fact it is the whole business, and worth going slowly over.

At the instant the market maker buys, those 8,000 shares are its shares, paid for with its money, and everything that happens to the price from that instant onward happens to the market maker rather than to the seller. The seller has gone home. The Rs 8,38,400/- is in the seller's account. The market maker is sitting on a holding it never wanted, that it took on because being willing to take it on is the service, and it now has to find somebody who wants it.

A great deal of the risk has quietly changed hands. Before the sale, the price falling was the seller's problem. After the sale, the falling price is the market maker's problem. The market maker took that problem on in exchange for Rs 0.40/- a share, and has not actually collected the Rs 0.40/- yet. Whether the market maker ever collects that Rs 0.40/- depends entirely on what happens next.

None of that has anything to do with what comes after the match. Once two orders meet, a clearing corporationA separate company that steps between the two sides of a matched trade and becomes the party each of them faces, so neither has to rely on the other. Covered separately. steps into the middle and becomes the party each side faces, and the depositoryThe institution holding securities in electronic form against a name, so a change of ownership is a change in a record rather than a movement of paper. Covered separately. updates the record of who holds what. Clearing and the depository record run identically whether the other side was a market maker or a schoolteacher in another city, and both are covered separately.

How does a market maker actually get paid?

By the gap, and by nothing else. The market maker buys at Rs 104.80/- and sells at Rs 105.20/-, so on a share it manages to buy and then sell, it has Rs 0.40/-.

The spread is only earned if both sides eventually turn up. A payment that conditional is payment for holding rather than a fee for a service. This is the sentence most readers slide past, so here it is as arithmetic. The market maker buys 8,000 shares at Rs 104.80/-, paying Rs 8,38,400/-. At that instant its earnings on this trade are exactly nothing. The market maker has spent money and acquired a holding. Later somebody arrives who wants 8,000 shares and pays Rs 105.20/- a share, or Rs 8,41,600/-. Only at that second moment does the Rs 3,200.00/- exist.

A market maker that buys and then cannot sell has not earned a spread. The market maker has bought a position, and the position is now doing whatever the price does. The difference between a fee and a spread is exactly that, and it is not a small one. A fee is money already in hand. A spread is money that arrives only if the second half of the trade happens, on terms the market maker cannot dictate.

What separates a market maker from a broker?

Market Maker vs Broker

Both of them appear on the same screen, both of them are involved when a client deals, and a great many explanations describe both as helping the client trade. The description is true and useless. Helping the client trade is what both of them do; it is not what separates them.

Each side is worth taking on its own terms first. A broker acts for a client. The broker carries the client's order to a venue the client cannot reach directly, checks it, stands behind what the client owes, and keeps the record. At no point in any of that does the security belong to it. Whether the price then goes up or down is nothing to do with the broker's own money, and its charge for the work does not change either way.

A market maker acts for itself. The market maker carries nobody's order anywhere. Instead it names two prices, deals at either of them with its own money, and finishes each transaction holding either more shares than it started with or more cash. Whether the price then goes up or down is very much to do with its own money.

One question separates the two, and no other test is required. Whose book does the security sit on at the moment the trade happens: the client's and a stranger's, or the market maker's? A broker never has it on its own book and is paid a commission for the arranging. A market maker has it on its own book and is paid by the gap between its two prices. Every other difference between the two comes out of that one.

The second consequence is the one most readers miss. A broker and a market maker are exposed to completely different things. Two different businesses happen to sit on the same screen. A broker's troubles are operational and reputational. A broker can send an order wrongly, keep a record badly or lose a client. A market maker's trouble is the price of what it is holding. Holding that price risk is not a matter of doing the job well or badly; it is the job.

Why does a spread widen?

Because the market maker is about to hold something for a length of time it does not control, and the wider the range of what might happen to the price in that time, the more it wants for taking the thing on at all.

Run it back through the phone shop. The shop is confident the shelf time is short on a common model it sells three of every week, so it will buy that one at a price fairly close to what it sells them for. Hand it an unusual model it has never stocked and the shop might be looking at that phone for six months, so the price it offers drops a long way below what it thinks it could eventually get. Same shop, same day, same willingness to deal. The difference is entirely in how long the shelf time might be and how much could happen during it.

A spread is a statement about how hard a security is to hold, not a statement about how greedy anybody is. Three things push it wider, and each of them is the same thing in a different coat. The first is liquidityHow easily something can be turned back into cash without shifting its price. A holding that is dealt in constantly is easy to get out of; one that is dealt in rarely is not., or rather the lack of it: if the security is dealt in rarely, the expected shelf time is long. The second is uncertainty: if something is about to be announced and nobody knows what, the range of what the price might be tomorrow is wide. The third is size: if a seller wants to sell far more than the market maker wants to hold, it will only take it on at a price that pays for the extra.

Which is why the cynical reading gets it exactly backwards. A quote that widens before an announcement is not somebody taking advantage of the seller. The wider quote is somebody saying, in the only language they have, that the thing they are being asked to hold has become harder to hold.

What happens when a quote disappears altogether?

Something worse than a wide spread. Past a certain point a market maker does not widen its quote further. The market maker stops quoting altogether.

The logic is not complicated. Widening works while there is still some price at which the market maker is willing to hold the thing. Sometimes the market maker genuinely cannot form a view on what the shelf time or the range might be. When there is no such price, there is nothing left to widen to. So it takes the quote down.

A wide spread is still a price that can be dealt at. No quote at all is not a price, and the difference between the two is one of kind rather than of degree. Somebody who needs to sell into a wide spread pays more than they wanted and goes home. Somebody who needs to sell into no quote does not sell. A seller facing no quote is not offered a worse deal but offered nothing, and the gap between those two is the gap between an expensive afternoon and being stuck.

The shape is the same in completely different settings. Where a market has one party willing to be on the other side and that party steps back, the market does not reprice. It stops. A market between banks with nobody standing in the middle behaves that way; a share with one market maker in it behaves that way; and the phone shop that puts up a sign saying it is not buying today behaves that way. Same shape every time.

What does a quoted price mean for the price actually dealt at?

Less than it appears, and this is where careful readers are most often quietly wrong.

There is no single price for a share. There is a price at which a holder can sell, and a higher price at which a buyer can buy. The number halfway between them is the one usually displayed, and nobody has offered to do anything at that number. Rs 105.00/- in this worked example is not a price anybody has committed to. The halfway number is the average of two prices that somebody has committed to, and averages are not offers.

A price on a screen raises the question of which of the two it is. If the price is the one halfway between, it says roughly where the two real prices sit and nothing exact about either of them.

The second half matters just as much and is easier to forget. A quote is good for a size. A quote to buy 200 shares at Rs 104.80/- and a quote to buy 80,000 shares at Rs 104.80/- are entirely different statements, and only the second one says anything about what a large order would cost. How much can be dealt at a quoted price before the price starts to move is called depthThe quantity that can actually be dealt at or near a quoted price before the price begins to shift. A quote can be narrow and thin at the same time., and a quote can be narrow and thin at the same time. A sale of 200 shares deals at the price displayed. A sale of 80,000 uses up the first quote. The rest goes on to whatever is behind it, and the sale finishes somewhere else.

What does one round trip actually cost?

The number is small per share, not small in total, and nothing about it will ever appear on a statement. Work it right through.

A buyer decides to take 8,000 shares. The screen says Rs 105.00/-. At that price 8,000 shares work out at Rs 8,40,000/-. The purchase deals at the price the market maker sells at, Rs 105.20/-, so Rs 8,41,600/- leaves the account. Later the same afternoon the buyer changes their mind and sells the lot. The sale deals at the price the market maker buys at, Rs 104.80/-, so Rs 8,38,400/- comes back.

Rs 8,41,600/- went out and Rs 8,38,400/- came back, so the afternoon cost Rs 3,200.00/-, and not one paisa of it was ever charged to anybody. There is no line item. Nothing was billed. The price simply was not the price on the screen, in one direction on the way in and in the other direction on the way out, and Rs 0.40/- a share on 8,000 shares is Rs 3,200.00/-.

One tile never changes, and that tile is the whole point of the control. Slide the spread from one end to the other and the round trip goes from Rs 800.00/- to Rs 6,400.00/-, or eight times over. The price on the screen reads Rs 105.00/- the whole way. The cost of dealing and the price on the screen are two different quantities, and only one of them is on display.

Who sets the conditions a market maker and a broker work under?

Four things covered in this guide are decided by an authority rather than by anybody in the market, and every one of them gets revisited. Each is set out below as a row naming the authority that decides it.