Rajandran R Telecom Engineer turned Full-time Derivative Trader. Mostly Trading Nifty, Banknifty, USDINR and High Liquid Stock Derivatives. Trading the Markets Since 2006 onwards. Using Market Profile and Orderflow for more than a decade. Designed and published 100+ open source trading systems on various trading tools. Strongly believe that market understanding and robust trading frameworks are the key to the trading success. Writing about Markets, Trading System Design, Market Sentiment, Trading Softwares & Trading Nuances since 2007 onwards. Author of Marketcalls.in and Co-Creator of Algomojo (Algorithmic Trading Platform for DIY Traders)

The Ultimate Guide to Understand Market Makers

6 min read

Market makers are firms or individuals that provide liquidity to the markets by continuously buying and selling securities. They mostly supply limit orders in the orderbook aka offer bid/ask quotes on both sides. Basically, market makers are HFT/Prop trading firms that are wholesale traders who build and manage their trading inventory. They buy low and sell high with their two-way quote offering.

Market makers are typically registered with the exchanges and are required to meet certain obligations, such as maintaining a minimum level of liquidity and providing two-sided quotes for a specified number of securities. In India, there are no official market-makers in India Equity Markets. However market makers provide liquidity in NSEIndia SME Emerge Platform for better price discovery and to provide two-way quotes with a minimum presence of 75% of the time during the trading session.

The concept of Market Makers in India

In the March of 1998, SEBI (Securities and Exchange Board of India) constituted a committee under the chairmanship of GP Gupta, who proposed the idea of having Market makers who could improve the liquidity of the illiquid shares. The committee, working under Gupta put forward several proposals and recommendations in this regard.

The concept of market making was first adopted In India by Over the Counter Exchange of India (OTCEI), a stock exchange that comprises of small and medium-sized firms. Nevertheless, the venture failed within no time. Instead, brokers willingly chose to be the market maker for the illiquid stocks, for the high percentage of profit involve with it.

Market Makers and HFT Firms

Market makers play an important role in the functioning of the securities markets by providing liquidity and enabling other market participants to buy and sell securities easily and at competitive prices. They also help to reduce volatility in the markets by providing a source of demand and supply for securities.

Market making is a common strategy used by HFT firms, as it allows them to provide liquidity to the markets and generate profits from the spread between the bid and ask prices. HFT firms use their advanced technology and algorithms to execute trades quickly and efficiently, allowing them to take advantage of small price movements and other market inefficiencies.

However, the use of HFT for market making has also generated controversy, with some critics arguing that these firms have an unfair advantage over other market participants. HFT firms are able to execute trades at much faster speeds than other market participants, which can give them an advantage in terms of being able to respond to market events and take advantage of price changes.

Market Making Strategies

There are several ways in which market makers can provide liquidity to the markets, including the following:

  • Providing quotes: Market makers continuously provide quotes for the securities in which they make markets, indicating the prices at which they are willing to buy and sell. These quotes are typically displayed on the exchange’s trading platform, allowing other market participants to see the current market prices and trade with the market maker.
  • Hit and lift: Market makers can also provide liquidity by “hitting” the bids and offers of other market participants. For example, if a market participant places an order to buy a security at a certain price, the market maker can immediately execute the trade by “hitting” the bid and selling the security to the market participant. This helps to fulfill the market participant’s order and provides liquidity to the market.
  • Crossing the spread: Market makers can also provide liquidity by crossing the spread, which means buying a security at the ask price and selling it at the bid price. This allows the market maker to profit from the difference between the bid and ask prices, while also providing liquidity to the market.
  • Passive quoting: In some cases, market makers may choose to provide liquidity by passively quoting prices without actively seeking out trades. This allows them to fulfill their obligations as a market maker without necessarily incurring any trading costs.

Advantages of Market Making

Market making provides several benefits and advantages to the financial markets, including the following:

  • Improved liquidity: By continuously providing quotes and executing trades, market makers help to increase the liquidity of the securities in which they make markets. This makes it easier for other market participants to buy and sell these securities and can help to reduce the volatility of prices.
  • Reduced spreads: Market makers often provide two-sided quotes for securities, indicating the prices at which they are willing to buy and sell. This helps to narrow the spread between the bid and ask prices, making it cheaper for other market participants to trade.
  • Enhanced price discovery: By providing liquidity and executing trades, market makers can help to improve the efficiency of the price discovery process. This can help to ensure that prices reflect the true supply and demand for securities, and can help to reduce the impact of market manipulation and other forms of market abuse.
  • Improved market efficiency: Market makers help to ensure that the markets are functioning properly and efficiently by providing liquidity and facilitating trade. This can help to reduce the transaction costs for other market participants and improve the overall efficiency of the market.

Overall, market-making plays an important role in the functioning of the financial markets by providing liquidity and enabling other market participants to buy and sell securities easily and at competitive prices.

Types of Market Makers

There are several different types of market makers, including the following:

  • Specialist firms: Specialist firms are market makers that are registered with a particular exchange and are responsible for providing liquidity for a specific security or group of securities. These firms are typically required to maintain a minimum level of liquidity and to provide two-sided quotes for the securities in which they make markets.
  • Retail firms: Retail firms are market makers that provide liquidity to the market by executing trades on behalf of their clients. These firms often use algorithmic trading systems to automate the execution of trades and to provide liquidity to the market.
  • Proprietary trading firms: Proprietary trading firms are market makers that trade for their own account, using their own capital to provide liquidity to the market. These firms often use complex algorithms and high-speed trading systems to execute trades quickly and efficiently.
  • Hedge funds: Hedge funds are investment firms that use a variety of strategies to generate returns for their clients. Some hedge funds act as market makers, providing liquidity to the market and executing trades on behalf of their clients.

The significance of the Market Makers in the Indian Financial Market

Due to lack of liquidity, investors are not willing to invest in several sectors of the market, this includes many small and mid-cap stocks and equity derivatives. There have been numerous cases in past, where the investors are unable to gain exit from several small and mid-cap stocks while correction, due to the absence of buyers who are interested in it. Hence, in such a scenario, market makers can buy the stock at the quoted price.

However, many times, experts have denied the significance of the market makers, as they find, the presence of the later distorts the natural market conditions. The market makers act as the wholesalers by buying and selling securities, experts felt that the prices would not affect the demand-supply scene.

Does Market Makers manipulate the Markets?

Market makers are not typically involved in market manipulation. Their role is to provide liquidity to the markets and facilitate trade, not to manipulate prices or engage in other forms of market abuse.

However, there have been instances in the past where market makers have been accused of engaging in manipulative practices. For example, some market makers may use their superior knowledge of the markets and access to sophisticated trading technology to take advantage of other market participants.

To prevent market manipulation, regulators such as SEBI in India have introduced rules and regulations that require market makers to operate in a fair and transparent manner. These rules are designed to ensure that market makers do not engage in manipulative practices and to protect the interests of all market participants.

How Option Market Making Works?

Option market makers use a variety of strategies to provide liquidity to the market and generate profits. For example, they may use delta hedging to manage their risk, or they may use complex algorithms to take advantage of arbitrage opportunities and other market inefficiencies.

Options market making can be a profitable business, as market makers can earn profits from the spread between the bid and ask prices, as well as from the premiums they receive for selling options. However, it can also be a risky business, as option market makers are exposed to the risk of large losses if the market moves against them.

Option market makers also use their knowledge of the market and the options they make markets in, to provide pricing and risk management services to other market participants. They may use their expertise to help other market participants to evaluate the risk of their positions and to hedge their exposure to the market.

Top Market Makers in the World

There are many large and successful market makers in the world, and it is difficult to say definitively which are the “top” market makers. Some of the largest and most well-known market makers include the following:

  • Citadel Securities: Citadel Securities is the market-making unit of the global financial institution Citadel. The firm is one of the largest market makers in the world, providing liquidity and executing trades in a wide range of securities.
  • Virtu Financial: Virtu Financial is a global financial services firm that specializes in market-making and electronic trading. The firm uses advanced technology and algorithms to provide liquidity to the markets and generate profits.
  • Susquehanna International Group: Susquehanna International Group, or SIG, is a global financial services firm that provides a range of services, including market making. The firm is known for its use of advanced technology and algorithms to execute trades quickly and efficiently.
  • Jane Street: Jane Street is a global trading and investment firm that is active in a wide range of financial markets. The firm is known for its market making activities, and uses advanced technology and algorithms to provide liquidity and execute trades.
  • Flow Traders: Flow Traders is a global market maker that specializes in exchange-traded products. The firm uses advanced technology and algorithms to provide liquidity and facilitate trade in a wide range of securities.

 

Rajandran R Telecom Engineer turned Full-time Derivative Trader. Mostly Trading Nifty, Banknifty, USDINR and High Liquid Stock Derivatives. Trading the Markets Since 2006 onwards. Using Market Profile and Orderflow for more than a decade. Designed and published 100+ open source trading systems on various trading tools. Strongly believe that market understanding and robust trading frameworks are the key to the trading success. Writing about Markets, Trading System Design, Market Sentiment, Trading Softwares & Trading Nuances since 2007 onwards. Author of Marketcalls.in and Co-Creator of Algomojo (Algorithmic Trading Platform for DIY Traders)

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7 Replies to “The Ultimate Guide to Understand Market Makers”

    1. Yes to do market making you need to register with NSE and exchange provides incentives too for providing liquidity in illiquid stocks and its applicable for futures and options segments too.

  1. Hi Rajandran,

    Like in NASDAQ Level II platform, which shows the market makers of a stock at a given time, is such information showed in Indian online stock trading platform. I believe if we can see this information, we can understand how the market makers are moving about the stock.

    I use sharekhan but haven’t seen that in their trading platform.

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