The more liquidity, typically, the narrower the bid-ask spread and the cheaper the implicit transaction costs. The bids and offers that market makers provide are often called liquidity. The spread, that is the difference between the bid price and the offer price in the market, is the implicit cost of being able to immediately trade (buy or sell) in the market. As compensation for taking this risk, the market maker earns a very small spread, often less than a penny per share.
A market maker doesn’t bet on the direction of the market rather, a market maker is really a risk transfer agent – someone who helps transfer risk between buyers/sellers in the market by bridging the gap in time between when you want to sell your shares and when someone else wants to buy those shares, or vice versa.Ī market maker bridges this gap by warehousing (holding) the risk – the position it just bought from you – on its balance sheet by using its own capital. If you want to sell 273 shares of, say, Facebook stock, what are the chances that at that *very* second, somebody else wants to buy precisely 273 shares of Facebook stock? Probably zero-queue the market makers. How does an order given to a broker like Robinhood or Schwab or ETrade become a trade? And if trading is now free, does this mean that you-the investor-are not the customer, but the product being sold? The answer (a definitive no) requires a closer look into the structure of markets and market making. Much of the recent scrutiny is based on a misunderstanding of the underlying market and the complexity of the forces driving it. In the wake of the GameStop short squeeze, payment for order flow-the practice of market makers paying brokers to execute customer orders-has fueled no small amount of debate: Is it a tactic deployed by large capital markets institutions to steal money from the less informed, or is it an enabler of low cost, highly efficient stock trading for all?
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