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Market Makers - What Is A Market Maker And Why Are They Needed?

Jun 2, 2008
A market maker is a stock brokerage firm, which is a member of FINRA (Financial Industry Regulatory Authority), formerly known as the NASD (National Association of Securities Dealers).

Market makers quote buy and sell prices for financial commodities, making a profit on the difference between the bid and the offer spread. The market maker gets compensated for providing liquidity in the market. A market maker is also involved with rule 15c211, in that a 15c211 is filed for a market maker to trade any given security.

When you buy or sell a stock or place an order with your broker, the transaction takes place within seconds. The process is quite simple for the buyer or seller, but the action takes place behind the scenes where the market makers line up the buyer with the seller and vice versa.

Without a market maker, it's very unlikely that you will be able to find a buyer or a seller for an exact number of shares at any given time. The market maker will buy a large number of shares from a seller, even when they don't have another buyer lined up. By doing this, they take on a huge risk. If the value of the stock falls while the stock is in their hands, they could lose a significant amount of money.

To prevent this from happening, market makers maintain a spread on every stock they buy. There may only be a $0.05 difference between the ask price (the price they buy it for) and the bid price (the price they offer to sell it for).

They sell to and buy from their clients in foreign markets, where most deal are done over-the-counter. By providing extra liquidity, this reduces the cost of transactions for clients and makes the trades worthwhile. If not for the market maker, they would have to accept a low price for the stock or not be able to trade it at all.

In the US, the AMEX and NYSE have a single exchange member, also known as a stock "specialist", who acts as the market maker for a given security. The specialist provides a required amount of liquidity to the market, prevents excess volatility, and takes the other side of trades when there are buy and sell imbalances in customer orders. Therefore the specialist is privy to trade execution advantages.

On the NASDAQ and other US exchanges, there are many competing market makers in any given security. They are obligated to buy and sell at prices matching their displayed bids and offers, and do not receive the advantages of a specialist.

Proponents of the official market maker system believe that market makers add to the liquidity of the stock and commodities markets by taking assuming risk and taking short or long positions, to hopefully turn a profit. On the London Stock Exchange, market makers can always buy and sell stock. Each stock always has at least two market makers that are obliged to deal.
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