What is a Market Maker?
This is a term you may have come across occasionally, but Market Makers have been in the news quite a bit in the past few weeks in reference to the “Flash Crash” that took place earlier this month. Unless you live in a cave, you’re probably aware that during the Flash Crash the Dow Jones Industrial Average fell 600 points in seven minutes and then gained it all back nine minutes later. This all started at about 2:40 PM EDT when the market was already down 400 points on fears of a Greek financial default. The alarming rate of the decline was at first blamed on a trading error, or “fat finger trade”, but that event has largely been dismissed as the cause. The focus of investigation into what caused the crash has now turned to automated computerized trading, but there are also many questions being asked about what role, if any, that market makers had in causing or contributing to the Flash Crash.
So just what is a market maker? Quite simply, it is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. These firms act as dealers who hold an inventory of the stock in which they “make a market”. They stand ready to buy or sell the stock at all times while the market is open. Market makers earn profits through the spread between the prices at which they buy and sell the stocks. Example: Let’s say that a firm makes a market in the stock of XYZ Corporation. XYZ has a current bid price of $20.00, and its current ask price is $20.05. The market maker will buy the stock at $20.00 and sell it at $20.05. The five cent difference is the market maker’s profit. Like in this example, the spread is normally only a few cents per share, but it can add up to a tidy sum at the end of the day. This may seem like easy money, but market makers bear the risk of loss if the price stock in which they make a market goes down.
Market makers keep things moving and provide the stock market with the liquidity needed to operate efficiently. Think about it, when a trade is placed with a broker, it is normally executed within seconds. This is due to the fact that market makers are always available to buy and sell. If you decide to sell 200 shares of XYZ Corp., it is unlikely that at that moment in time a particular buyer will be looking to buy exactly 200 shares of XYZ. But a market maker will buy your stock regardless and keep in inventory with other shares of XYZ to be held or sold later. For every stock there are several firms who act as market maker. This serves to increase liquidity and it promotes fair pricing through competition.
The SEC and NASDAQ are examining the actions of market makers during the Flash crash for two primary reasons. First, it has been reported that during the 16 minutes of near chaos, market makers seemingly ignored higher bids and stocks were sold to lower bidders. Second, some market makers apparently stopped trading altogether, thereby severely impairing the liquidity of some securities. This possibly exacerbated the extreme price drops that occurred. The initial downturn created a large group of sellers looking to bail out. In the absence of the market makers, simple economics dictated that prices would continue to decline because of the large supply of sellers and lack of available buyers. Authorities are still sifting through the rubble in the aftermath of the Flash Crash. It remains to be seen who or what will ultimately be blamed, and whether any regulation is proposed to prevent a similar event in the future.