What Is Market Making?

5 min read

Financial Markets

A financial market is a market where participants can trade securities or other financial assets. The New York Stock Exchange is an example of a financial market, but there are many other stock exchanges, and stock exchanges are not the only types of markets. There are many different markets across the world with their own specific mechanics and assets being traded. Today the vast majority of transactions on markets take place online, but in person trading is also possible. In the context of Bitcoin, a market is any platform that connects Bitcoin buyers and sellers.

Who Participates in Markets

The traders in the market are engaging with the market every time they make a trade. Every transaction will have a buyer and a seller representing opposite sides of the trade. Traders can switch between buying and selling, and if the market hosts several assets, traders can participate in trades with any of them. Traders may also be engaging with the market in ways other than executing orders. Traders commonly use markets to reference prices of assets or place orders that don’t instantly result in transactions.

Another key participant in markets is the market itself. Markets can be centralized or decentralized. Many decentralized exchanges host markets for Bitcoin and other goods and services. Markets require organization, transparency, and trust, and centralized markets often offer greater efficiency than decentralized alternatives. In order to achieve this, most major markets are owned and regulated by a company who is responsible for the logistics that go into the market’s operations. The market owner is responsible for ensuring everyone gets the assets they are entitled to, solving the issue of trust that arises when trading with an unknown counterparty. Additionally, the market owner provides participants with market data and acts as the platform for traders to submit their orders.

Market Mechanics

There are two main ways that a trader can place an order on a market, regardless of whether they are the buyer or the seller. The first way is through a market order. A market order is an order to buy or sell an asset at the best price you can get right now. A market order will require the direction of the trade (buying or selling) and the quantity to trade. For example, a market order to buy 100 shares of Apple is a request to buy 100 shares immediately at the lowest price available.

The second way to place an order is a limit order. A limit order is a request to buy or sell an asset, but only if you can do so at a certain price or better. A limit order will require the direction of the trade, the quantity to trade, and the limit price. A limit order may also have an expiration point when the order will automatically be cancelled if it hasn’t executed yet. For example, a limit order to buy 100 shares of Apple with a limit price of $100 is a request to buy 100 shares, but only if you can do so for $100 per share or cheaper.

Every transaction has an aggressor and a passive participant. The aggressor’s trade will execute right away, matching with the existing order placed by the passive trader. An agressing order is either a market order or a limit order with a limit price that can be satisfied right away with the existing limit orders on the market. Conversely, the passive trader placed their order on the market and had to wait until the aggressor accepted it for their order to execute. A passive order will always be a limit order with a limit price that could not be satisfied at the time of creation. Passive participants and aggressors can also be called makers and takers, respectively.

Every time a buyer and seller are willing to transact at the same price a transaction will occur, removing this common ground from the exchange. This results in a constant bid-ask spread where the highest price a participant is willing to pay is lower than the lowest price a seller is willing to sell at. This spread will make it harder for traditional traders to transact because the actual price of execution will differ from the mid-market price.

A bid-ask spread is the difference between the lowest sell offer and the highest buy offer on a market.

Market Makers

Market makers mitigate the issue of bid-ask spreads by maintaining open orders to buy or sell the same asset simultaneously. Capitalizing on the existing spread, market makers will always be willing to buy the asset for less than they are willing to sell it. The result for the market maker is a very high quantity of offsetting trades that make money based on the spread. The market maker’s presence also benefits other market participants by keeping the spread low and adding liquidity to the market. Unlike many traditional traders, the market maker is generally expecting to profit based on market mechanics instead of an investment strategy that expects the appreciation of the financial assets being held. Market makers will need to have a large sum of liquid assets at any given time and are usually a large financial institution.

In addition to giving their counterparty the agreed asset from the trade, traders must compensate the market owner for facilitating the transaction. This is done by paying the market owner a predetermined fee. The size of the fee depends on a multitude of factors including: the market being used, the asset being traded, the size of the trade, and whether the trader was the maker or the taker. In general, the fee will be a percentage of the trade, with more liquid assets having lower fees, and makers paying less than their taker counterparts.

Key Takeaways

  • Financial markets facilitate the trading of financial assets across many participants. These markets are usually owned by a company who maintains the market’s fairness.
  • Market mechanics result in a constant spread between the highest bid and the lowest ask price.
  • Market makers are willing to buy or sell the same asset, profiting on the bid-ask spread.