Market Makers and Liquidity Providers

 In the context of an efficient and liquid market, there exists a cipher of continuous and dynamic activities among trade execution, price accuracy and stability, and trader buy/sell activity that will—and must—occur at the market-mechanism conjunction to facilitate trading so that the trading needs of buyers and sellers are met or satisfied.

This activity consists of market makers and liquidity providers, who are the informal entrepreneur functions within financial markets and remain discrete (and inconspicuous) participants; however, their functional role is indispensable as they institute liquidity in the marketplace so that the next buyer can find a willing seller—without those functions prevailing, markets would be slower, bumpier, and less efficient.

Understanding who the market makers and liquidity providers are, how they function in the marketplace, and their functions offers a glimpse into the applications in finance that most investors seldom will witness first-hand.

Market Maker Defined

Market makers (MMs) are firms or individuals that commit to quoting both buy and sell prices for financial instruments (e.g., stocks, bonds, currencies, or derivatives) so that there is always a trade occurring. By doing this, MMs "make" the market for that instrument (hence the name).

MMs earn revenue from the bid-ask spread (the difference between the price at which they will buy the security (bid) and the price at which they will sell the security (ask). While the spread on an individual trade may be only a few cents, MMs will do plenty of trades; in short, it adds up to a scalable business over a variety of instruments to participate in.

Liquidity Provider Defined

A liquidity provider is a more vernacular term for any entity that provides sufficient buying and selling mechanics so that the marketplace is active. Although market makers and liquidity providers are frequently the same, not all liquidity providers are necessarily market makers in the traditional sense.

In the case of the forex (foreign exchange) market, for example, the banks with which we trade are liquidity providers as they quote prices to brokers and other banks and financial institutions. A liquidity provider's role is to provide sufficient liquidity to ensure orders are executed quickly and reliably without significantly altering the price.

Market Makers and Liquidity Providers: The Difference

Although the two terms may be synonymous, they do have some distinctions.

• Market Makers actively give you buy and sell prices and are willing to trade your position at that price once you decide to do the trade. They have agreed to be live and available for that market at all times and understand the associated risks.

• Liquidity providers will not always give a price but will perform trades that create enough activity for you to get in and out of positions quickly without moving the market.

So, if we think about market makers as a storekeeper who is ready to sell you something or repurchase it at an agreed price, a liquidity provider is more like a wholesaler making sure that the store always stays stocked.

Why They Matter

Without Market makers and liquidity providers, we would be on a very rocky road trying to trade. You would place the order to buy shares, but you might have to wait a few minutes or even hours until someone is willing to sell to you. Prices would be jumping everywhere with each large trade because there would not be any orders on the other side to balance it.

Because they exist, we have:

• Tighter Spreads - this means it costs less for everyone to trade.

• Faster Execution - your orders are executed instantly.•   Stable Pricing – Larger trades do not always mean extreme price swings.

• Market Confidence – Traders are confident they can open and close positions freely.

How Market Makers Function

Market makers maintain trading systems and complex algorithms providing real-time pricing updates for buy and sell quotes from the marketplace. These systems make use of:

• Supply/demand of the asset.

• Latest trading activity.

• Current larger market activity and news.

Game makers must also contend with risk. If a market maker buys shares before they can sell them and the price drops, it could lead to a loss for the market maker. To mitigate their risk, market makers, in most cases, will hedge their positions with other assets or derivatives.

Encroachment of Technology

The advent of high-frequency trading (HFT) has changed the way market makers and liquidity providers work. HFT trading allows managers to continuously update their quotes within milliseconds of market supply and demand changes.

The less critical advantage of HFT for market makers and liquidity providers is speed of execution, and improved trading experience is now the norm through tighter spreads and trade execution. However, with a speed improvement comes greater competition. HFT is only a viable option for those trying to stay alive with an advanced technological infrastructure.

Risks

Market makers and liquidity providers provide stability for other market participants, and they each face their challenges and risks:

• Inventory Risk – The risk of holding an asset that may drop in value.

• Volatility – The risk of the market making sudden changes, and market makers and liquidity providers sustaining a loss quickly.- Regulatory pressure - Different countries have different rules, and these rules can have ramifications with how a firm operates.

- Competition - As more participants enter this space, the profit potential can decrease in some instances.

In extreme market conditions (flash crashes, etc.), market makers may temporarily disengage, and that can further decrease liquidity and worsen volatility.

Real-World Examples

As with stock markets, many firms like Citadel Securities and the Renowned Virtu Financial are extremely popular market makers. There are specialized liquidity providers in the cryptocurrency space who can help exchanges ensure there is enough trading activity to meet user demand.

Even in commodities like oil or gold, liquidity providers provide vital market-making services so producers, buyers, and speculators can transact without much liquidity risk or price delay.

Impact on Everyday Traders

Most retail traders may never have any interaction with a market maker; however, any time a retail trader trades, they do benefit from (invisible) market maker liquidity provision. Tight spreads on major currency pairs, completed orders - often instantaneously, and price stability in some significant markets are due to the liquidity provision by some of the participants in the market.

If there were no market makers, costs would be higher, execution slower, and volatility much greater.

The Future of Market Making and Liquidity Provision

As markets evolve, so too do market makers and liquidity provision participants. The introduction of decentralized finance (DeFi) has provided birth to automated market makers (AMMs). AMMs function with smart contracts and can determine an asset price and/or execute trades without human intervention.

It makes sense that traditional market makers will continue to dominate in regulated markets like stocks and bonds. Still, parts of the market may continue to reshape with the growin effect of blockchain based systems.

And...with the evolving focus on sustainability/ethical finance, liquidity providers may consider the social and environmental impacts of the markets they support.

Conclusion

While they may be offstage, market makers and liquidity providers are just as vital as all the other participants in the modern trading ecosystem. By making markets liquid, efficient, and stable, they create an environment where investors, ranging from the most prominent institutions to smaller retail trades, can buy and sell with minimal hassle.

Market makers and liquidity providers are the unsung heroes of finance. They provide the roadway that connects buyers with sellers while simultaneously facilitating the unrestrained flow of capital around the world.

Utilizing algorithms and blockchain-based solutions reaches into every market participant we have discussed.  Without them, markets everywhere would perish.