What is Market Making? A Short Explanation.
Buy low and sell high, this is usually the advice given to any beginner trader. The first difficulty is indeed to know how to time the market but the second and not least, there must be a buyer at the price where you want to sell.
Today we are going to take a look at how the financial markets work and in particular the role of the market makers. You don't know what they are? No worries, we'll explain! Are you ready? Let's get started!
How does the stock market work?
The stock exchange is a market where capital providers and applicants meet: through a central computer. The exchanges concern property securities (shares) and/or debt securities (bonds).
There are two main demanders: the State (Treasury), and private and public companies on the other. In order to carry out its economic policy, the government appeals to national and international investors by issuing, for example, Treasury securities, while companies turn to the stock market to find the necessary sources of financing for their development.
The supply of capital is determined by investors of different origins (individuals, companies or financial institutions). These investors exchange their financial resources for securities issued on the stock market.
Supply and demand
You have probably all heard of supply and demand, the law that regulates the exchange of goods and services in the world. The idea is simple, if from one day to the next a good becomes more available, its supply increases, but its demand does not move, the price should then decrease to find a new equilibrium.
In another case, if the demand for a stock or a crypto increases but its supply remains the same this should result in a price increase, all other things remaining equal.
On a centralized exchange platform or on the world's stock exchanges there is a tool called the order book. This is where you will find all your limit positions, both buying and selling. Of course, it may be that at the price you want to sell your asset, no one wants to buy it and vice versa.
The role of market makers
Let's assume that you are a small player on the world's stock market and that your prices do not match, the market for this asset could therefore remain at a standstill for some time. That’s where the market makers appear!
Another name for market makers is "liquidity providers," which is a nebulous description of what they actually accomplish. Large banks or other financial organizations that act as market makers ensure that the market operates properly by adding liquidity to it.
Simply put, they make sure that financial assets can quickly be converted into "useful" money. If you want to sell an asset, they are available to buy it; if you are going to acquire, they can also sell it. In exchange, they make money on the spread.
Foreign exchange frequently uses market making, where the players are typically banks and foreign exchange companies. In theory, a person may also "be a market maker," although this is severely constrained by the scale of the investment needed.
How do they make money?
Market making is associated with a risk transferred to the trading books. To compensate for this risk, a market maker earns a fee in the form of commissions or a spread. Unlike traders, a market maker does not raise money by buying low or selling high. There is two main sources of revenue for the market makers :
Spread between Bid and Ask
Participants buy at the market makers' bid and sell at their offer. They keep the difference - the more trades, the greater the profit. However, spreads tend to be tighter for the most actively traded securities, as there may be many competing market makers for a given asset.
Commission
High volume clients, such as brokerage firms or crypto projects, are charged a fee. Generally, these fees are not performance-based and are charged for services in general. Otherwise, it would create a conflict of interest between the client and the market makers.
Conclusion
In the world of classical finance and on centralized exchange platforms, the way to operate is the orderbook. In order for the orderbook to remain liquid and for each position to find a counterparty, it is necessary to employ the services of one or more market makers.
For the biggest securities or cryptos, it is indeed not uncommon to have several market makers who share the profit opportunities thanks to the spread.
More specific to the small crypto project, when they are listed on exchange platforms, liquidity is of paramount importance at the risk of being perceived as illiquid.