What Is a Market Maker? Role, Spread and How They Work

Market Maker: Definition

When investors and traders buy shares, those shares don’t come out of nowhere. And when they sell shares, those shares have to end up somewhere. This is where the market maker steps in. Market makers are individuals or entities that provide liquidity to the market. To do so, they hold large quantities of shares in one or several specific securities. On top of that, they stand ready to buy or sell shares at any time, no matter how the price swings. Put yourself in their shoes — it’s no small feat! You have to be willing to buy anything at any price. Now, I wish you an effective trading course: enjoy the read!

Market makers are major players in the financial markets. They make it possible to quickly execute the buy and sell orders placed by individual and institutional investors. The NYSE and the Nasdaq, like the crypto exchanges, rely on market makers to keep trading fluid.

The Spread: Definition

For a given security, a market maker quotes two prices.

1. The Ask

It is a higher price than the one at which he is willing to sell.

2. The Bid

It is a lower price than the one at which he is willing to buy a security.

The difference between these two prices is called the spread — i.e., the gap between the bid and the ask.

Among the exchanges that bring together the best market makers, I recommend Bybit. As long as they keep offering their service on derivatives, they rank among the best thanks to their liquidity. Bybit is normally where the spread is the tightest and buying/selling is the easiest: fast and precise.

Market Makers: Transaction Facilitators?

Holding large quantities of securities and standing ready to buy/sell at any moment, the market maker creates liquidity. So-called “liquid” shares are easy to buy and sell quickly, and the liquidity provided by market makers is largely what allows shares to trade efficiently between retail traders, companies, institutional investors and the other players in the stock market.

Market Makers: Are They Profitable?

Market makers quote two prices for a given stock at any given moment. The Ask is the price they are willing to pay for a particular share. While the Bid is the price at which they are willing to sell that same share. For any given stock, the price a market maker asks is always higher than its bid.

By buying shares at a lower price and selling them at a slightly higher one, the market becomes more fluid as it facilitates many buy and sell orders over time. This is what motivates them to take part in the market: they provide liquidity to traders and, in return, they pocket the difference (the spread) between the bid and ask prices of the shares for which they provide liquidity.

Market Makers: Their Role on the New York Stock Exchange (NYSE)

The NYSE, the leading U.S. stock exchange, operates as an auction market. This means that bids and asks are analyzed and matched to execute transactions. Once known as “specialists”, they are now called ”designated market makers,” or DMMs.

The DMMs of the New York Stock Exchange specialize in one or several securities, for which they facilitate fair and orderly trading by providing the following services:

• responsible for displaying all bids and asks and executing every viable transaction at the best market price.
• sets the opening price of the security in which it specializes. Sometimes this price matches the close of the previous session. Other times, it adjusts based on the news and events that occurred after trading hours.
• responsible for accepting, managing and executing all limit orders for the security in question.
• The DMM must also balance buying and selling interest for the stock in which it specializes by buying large quantities of shares during collapses and selling large quantities of shares from its own inventory during periods of heightened buying interest.

Market Makers: Their Role on the Nasdaq Exchange?

The Nasdaq Exchange, the second-oldest U.S. stock exchange, operates as a dealer market. Here, market makers have somewhat simpler responsibilities. On the Nasdaq, the large investment firms compete with one another to ensure that investors and traders can obtain the best available price when they buy and sell shares.

For any given stock, each market maker for that stock maintains an inventory of shares and provides public bid and ask quotes. Buyers and sellers are then matched electronically at the best available price. That is when their transaction is executed.

Market Maker vs. Broker: What’s the Difference?

Brokers are licensed professionals who buy and sell shares on behalf of their clients. In the past, most brokers were individuals who worked on commission and charged trading fees, but nowadays many investors use discount brokers, which let you trade fee-free through an online brokerage platform. However, there are also full-service brokers: they provide financial advice and personalized services, but for a fee. In short, a broker connects investors to the stock market.

Market makers, on the other hand, are generally institutions such as banks that hold large quantities of shares. They are willing to buy and sell shares quickly. This allows transactions to be carried out instantly, without retail buyers having to wait to be matched with retail sellers. In other words, a market maker creates the liquidity needed for efficient trading between brokers, on behalf of their clients, the investors.

Market Makers: The Potential Losers?

Market makers can lose money, under certain circumstances, on certain transactions. For example, if they buy a share from an investor on a bid of $100. Then, if the share’s value drops rapidly, they may be forced to sell that share at a loss. Say at $80 — a loss of $20. That said, market makers generally deal in high-volume stocks and facilitate many transactions every day, so they buy and sell shares quickly enough to make money on the spreads between the bid and ask prices, whatever direction a stock’s price takes.

That said, if a stock they handle starts losing ground quickly and keeps falling for a while, a market maker can end up losing money in the short term.

On the FOREX as Well?

Forex = the foreign exchange market

Just as in the equity markets, market makers exist in the foreign exchange market to improve liquidity and facilitate efficient transactions. Equity market makers are generally large banks and institutions. At any moment, they stand ready to buy and sell large quantities of currency. Transactions are then carried out at the current exchange rate.

And in Crypto Trading?

There are market makers in cryptocurrencies. But this role is considered risky, because cryptocurrencies are seen as too volatile. Some cryptocurrency markets can sometimes be less liquid than the equity markets, especially when it comes to smaller, more obscure cryptocurrencies. For these reasons, it is far easier to lose money as a cryptocurrency market maker than as a stock or currency market maker.

The Crypto Market: Good… and Bad Market Makers?

Moving from the relatively “boring” traditional markets, like stocks or currencies, to the ultra-dynamic crypto market can be refreshing. Light regulation, high volatility, exciting instruments and exchanges that let us take positions of every kind.

However, since today’s regulation still leaves many legal loopholes, some unscrupulous players don’t hesitate to rush in and cross over to the dark side… like certain Market Makers tempted to meet the demand for Volume or a Price Boost on projects moving from the ICO (Initial Coin Offering) to listing, for example, and likely to generate big gains in a short time.

In this specific case, we can suggest that there are 2 types of players who call on the services of Market Makers:

1) Honest Crypto Projects

When they mean well, the founders of crypto projects — although they obviously want a good return on investment — mainly want to increase a project’s short-term visibility and attract more investors while abiding by the code of good conduct of the business world.

A word of caution, though: the road to Hell is paved with good intentions, and Market Makers are no exception.

Indeed, some crypto project managers may see these practices as just another marketing tool, without realizing the negative long-term implications for the token’s reputation. They may also simply be unaware of what constitutes good market-making practice. Good intentions, then, are not enough. To be good, Market Makers need experience and a long-term vision for the crypto projects they choose to promote.

2) Dishonest Crypto Projects

There are indeed projects whose founders are simply dishonest. I’m talking about those who want to hide the fraudulent nature of their ICO by generating fake market demand once it’s listed.

The Good Market Maker: A Definition

One of the goals of this article is to help you carve out a safer path through the jungle of the crypto market… So let’s continue with the definition of what a good Market Maker is, one who steps in after an ICO!

Of course, as in any financial market, there will ALWAYS be a rotten apple, or even a few crates of them… That said, it’s important to understand that without Market Makers, the modern stock exchanges and trading venues as we know them probably wouldn’t exist.

In this jungle, a “good” Market Maker can only guarantee results on the things it truly controls, such as the spread and the size of its offer.

These are the two main services a Market Maker can guarantee.

Conversely, the players who come to us from the dark side will be inclined to promise a “certified” trading volume and, why not, a price rise up to certain levels …

Market Makers: The Good Side of the Force

Market Makers: The Aspirin of the Markets

As everyone knows, aspirin thins the blood. In the same way, good Market Makers keep the market flowing.

As we saw above, the role of Market Makers is to provide liquidity, bridging the gap between buyers and sellers and ensuring orders are validated.

Come rain or shine, Market Makers will be there to take short-term risks. They offset this with a large number of transactions in both directions in order to maintain steady profits and ensure their survival.

They benefit from transaction volumes and will naturally be present in high-volume products, like bitcoin, and the coins with the best fundamentals.

Less liquid tokens are less likely to attract Market Makers, because it requires especially significant resources: sure, it’s more lucrative, but it’s far more demanding and risky!

Market Maker: A Commitment

Under these conditions, the only thing a Market Maker can reasonably commit to is providing a constant spread between bid and ask within a defined price range for the duration of the service commitment.

The good Makers who work in the crypto sector have their own software running their own algorithms. This is in fact absolutely necessary in order to carry out thousands of transactions a day. Of course, one or more specialized professional traders are dedicated to keeping a close eye on the market.

Those in charge are supposed to act as referees and not take sides. They are there to help optimize and smooth the relationship between sellers and buyers. In this way, they help achieve the goals of an optimal spread between bid and ask, but this is not supposed to have a deliberate, predetermined influence on the other parameters, in particular the price and the trading volume. A good Market Maker stays neutral and impartial.

The arrival of a Market Maker in a market is generally positive … provided the coin has solid fundamentals that attract investors and traders.

Market Makers and Order Flow: What’s the Connection?!

Market Makers: The Dark Side

A Bad Market-Maker Practice: Wash Trading

Those who call on Makers’ services will surely recognize them by their fine promises, such as the guarantee of minimum trading volumes.

The most common strategy to achieve this is “wash trading.”

In practice, this strategy consists of a trader filling their own orders. A novice would go about it like this: they would simply place a large buy order and fill it almost instantly with their own sell order.

A more “sophisticated” player would spread their orders over a wider price range and place them over longer periods. It’s also possible to operate across several accounts in order to avoid being detected by the exchanges’ “police.”

Volume manipulation in the crypto sector is nothing new. That said, now you know how it works!

It is, nonetheless, a practice that has been banned on the traditional markets since 1936 in the United States.

To this day, any regulated exchange has at least a prevention mechanism against “self trading” or “wash trading.”

Wash Trading: Regulators Are on the Lookout!

It’s not hard to find the case law and the fines, larger or smaller, that come with proven cases of market manipulation.

This is the kind of thing that should wreck the reputation of a token or an exchange when wash traders get caught. Yet it doesn’t, because in the crypto market there is still no regulation on this point, even if those who watch over the protection of the financial system in place regularly promise us to bang their fist on the table and stir up the anthill. For now, draft regulations are in the pipeline, both in the USA and in Europe. So, still nothing very concrete in force, even if the vice is tightening. This is probably one of the reasons the crypto market remains attractive.

Until now, among the large crypto exchanges, the tendency was rather to avoid the prevention mechanisms normally intended to prevent self-trading, because it forced them to give up a significant trading volume.

However, especially after the FTX affair, the Exchanges want to restore a positive image of the crypto market, which is why they are trying to stand out by offering this kind of safeguard.

Wash Trading: What’s the Solution?

The simplest technical solution is to prevent self-trading by enabling the self-trading prevention feature. The point is to ensure that orders from the same account cannot be matched with one another. This could be problematic for savvy traders who run several models. They could end up trading with themselves. However, in almost every case, the trader should be able to work around the problem with an internal matching system, assuming they have a trading platform with sufficiently advanced features.

With this simple solution, an exchange can weed out the lazy players who aggressively wash-trade on the same account.

Binance and Bybit, for example, now offer “Self-Trading Prevention” algorithms.

This is a real competitive advantage for these platforms. Especially for the Exchanges on which new coins are listed following an ICO. Indeed, it allows them to protect their clients and thus spare them a flight of capital. However, this reasoning may no longer hold when the Market Maker and the Exchange belong to the same entity.

The real problem arises when market makers are asked to hit certain volume levels, because that is exactly what pushes them to wash-trade. In that case, sure, they honor their contract and get paid in return. But that isn’t enough to make them good Market Makers. The lure of easy money tends to corrupt them.

So it’s better to hope that the project isn’t merely an object of manipulation and that the hoped-for volumes are reached naturally through a good source of liquidity.

At first glance, Wash Trading looks like a victimless crime, but let’s not trust appearances! Granted, there is far worse, far more insidious than wash trading, but you’ll see that this fraudulent practice remains a real long-term problem.

A Market Maker that guarantees a certain level of volume in the crypto sector may be well-intentioned at first, but if it has little experience in the field, its intentions are likely to come to nothing.

As for those who make enticing promises by guaranteeing a rise in the coins for which they undertake to provide liquidity, it’s clear that good intentions are not what drives them. Besides, can we really still call them Market Makers?!

The Schemes of Market Makers

Price Manipulation: The Different Forms

Price manipulation comes in different forms in the crypto market:

The most common ones are:

1. Pump and Dump
2. Ramping
3. Cornering

1. Pump and Dump

It’s the mother of all price-manipulation tactics. Put together a team, buy a coin and start promoting it on social media. Once its notoriety takes off enough, sell it for a nice profit. All of this can be done in a single working day, behind the anonymity of a Telegram channel.

No need to remind you that I strongly advise against joining a Pump and Dump group, because there’s a very high chance that you’ll be the one left holding the bag!

It’s also worth warning you that on the other side, you also have ill-intentioned market makers lying in wait for you with coins whose volume they’re already boosting through wash trading!

2. Ramping

In finance, ramping consists of trying to drive up the price of a stock and of the company behind it by buying shares on the market in order to increase demand. If the price rises, the ramper can turn a quick profit by selling. This behavior obviously constitutes market abuse and is illegal.

In practice, ramping consists of creating the impression that big buyers are very active in a market, which gives it a very positive image in the eyes of the other players, retail traders in particular. Of course, it’s the same player. It’s easy to be misled by this behavior, and other unsuspecting traders may feel compelled to “front-run” these so-called big buyers and end up losing.

A crypto Market Maker can use this tactic by creating a phantom buyer that makes large transactions over a fixed period (for example, every day), which gets the market used to this behavior and drives prices up.

Needless to say, once the price target is reached, the mission is over. The big buyer mysteriously disappears, and the token’s price is very likely to collapse.

3. Cornering

In finance, cornering a market consists of gaining enough control over a stock, a commodity or another particular asset in order to manipulate the market price. One definition of cornering a market is as follows: “to hold the largest market share in a particular industry without having a monopoly.”

Companies that have cornered their markets have generally done so in order to gain more room to maneuver in their decisions; for example, they may want to charge higher prices for their products without fearing that they’ll lose too much business. The cornerer hopes to control a large enough share of the commodity’s supply to be able to set its price.

This is a classic strategy in the commodity markets, where supply is limited. It’s also very hard to hold short positions over extended periods.

Likewise, in the realm of the crypto market, small tokens follow the same supply pattern. A fake Market Maker has little chance of achieving its ends by trying to buy up a large portion of the available tokens if it’s the only liquidity provider. However, it can use this tactic when there are other market makers for the same token. The goal is to seize their inventory and force them to raise prices, because they are contractually bound to maintain a certain spread level!

These three price-manipulation practices (P&D, ramping and cornering) are absolutely prohibited. They are even considered criminal in the regulated space, and for good reason. They disrupt the market, erase trust in the traded asset and make good players lose money in the long run.

It can be tempting for some players to enter into a crypto market-making agreement with the promise of a price rise… After all, it’s so exciting to watch your project appreciate! What can go unnoticed, however, are the consequences of these tactics.

Market Makers: Price Manipulators?

The long-term consequences of price manipulation.

Both the price and the trading volume suffer, in one way or another, from manipulation. In fact, the results can be disastrous in the long run, with compounding effects on reputation and on relationships with investors and exchanges.

One of the easiest consequences to notice shows up as disappointed expectations.

It’s normal to expect trading to “die down” a bit after the listing of a recent ICO.

However, a stable trading volume and a rising price that suddenly evaporate inevitably lead to the conclusion that an entire project is low-quality, or even a scam.

The project loses the trust of its early investors, the very ones who are supposed to be the project’s long-term ambassadors.

The project loses the trust of the exchanges where they applied for their listing, and it can be delisted fairly quickly.

In the event that the project is listed on a fine exchange, it’s quite possible that the project will be kicked off for good, its founders included!

Finally, when it comes to the reputational effect, you should know that a good number of the professional investors, exchanges and venture capital firms active in the crypto sector actually come from more traditional financial backgrounds.

And these players are very quick to spot bad practices, and once they have, the founders’ reputation is destroyed, even if the founders were unaware of those practices.

Conclusion

As you’ve gathered, as everywhere, there are good ones and bad ones: Market Makers who do their job well by providing liquidity and facilitating trading in the markets, and the ill-intentioned ones who are still far too numerous in the crypto sector and who are only there to gorge themselves on the cheap. Those are as dangerous as a wolf in the sheepfold …

They are certainly indispensable, since it’s nearly impossible to trade without them, but we must stay cautious when we choose coins to trade! Don’t hesitate to head over to Coingecko or CoinMarketCap and carefully examine the fundamentals: the coin’s utility, the team, the market cap, and so on …

Favor coins with a long track record and projects that display solid fundamentals; that will keep you from getting caught up in moves engineered by the players whose practices you now know!