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Obtaining Capital: Methods of Long-Term Financing
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Finance Textbooks Boundless Finance Obtaining Capital: Methods of Long-Term Financing The Role of Investment Banks in Financing
Finance Textbooks Boundless Finance Obtaining Capital: Methods of Long-Term Financing
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Finance
Concept Version 6
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Market Maker

Market makers provide liquidity to securities markets by submitting both bids and asks on a security.

Learning Objective

  • Explain the role of market makers


Key Points

    • Without sufficient liquidity, markets would become more inefficient because there may not be a buyer/seller to transact with, even at what should be the market price.
    • Market-designated market makers provide liquidity by submitting both bids and asks on certain securities. This helps ensure transactions can occur at the market price.
    • By submitting bids below ask prices, the market maker can make money.
    • The difference between the highest bid and the lowest ask price is called the bid-ask spread.

Terms

  • liquidity

    Availability of cash over short term: ability to service short-term debt.

  • bid-ask spread

    the difference between the prices quoted for an immediate sale and an immediate purchase

  • bid

    The submitted price at which the trader is willing to buy.

  • ask

    The submitted price at which the trader is willing to sell.

  • bid price

    the amount offered by a buyer


Full Text

The price of a stock is determined through a simple process of matching buyers and sellers. All those who want to sell the stock say the price at which they're willing to sell a certain number of shares (the ask price). All those who want to buy say the maximum price they're willing to pay for a certain number of shares (the bid). The difference between the highest bid and the lowest ask price is called the bid-ask spread . If the one person's bid equals another's ask price, they have found a price at which they're both willing to do business, and the transaction occurs. The mutually agreeable price is then inputted as the stock price.

New York Spot Prices

The highest price someone is willing to pay (bid) for gold is $742.30 and the lowest someone is willing to accept (ask) is $743.30. There is a bid-ask spread of $1.10.

In major stock exchanges (such as the New York Stock Exchange) there are enough people who want to buy or sell at any given time that it's generally easy to find someone to transact with if you're making a bid/ask near the last price. This is called liquidity.

But what happens if there is no liquidity? Since there aren't very many people looking to trade the stock, the highest bid may be significantly lower than the lowest ask price, so no transactions occur. A lack of liquidity is really bad for investors. If they don't think they can buy/sell the stock when they need to, they will choose to just not deal with it.

That's where a special type of trader comes in. They are the market makers. Market makers are a company or individual that quotes both an ask price and a bid. This helps to provide liquidity to the market, making the market more efficient. For this reason, many exchanges (such as the New York Stock Exchange and American Stock Exchange) have designated market makers for certain securities.

The financial reason why market makers do this is because the ask price that they submit will always be slightly higher than their bid. It is the bid-ask spread that provides the money-making opportunity. A bid-ask spread of even a cent can mean a huge profit when trading thousands of shares.

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