Definition
A market maker is a dealer in securities on exchanges like the London Stock Exchange, who pledges to be willing to buy and sell securities. Acting as a principal, they set both buying and selling prices for securities at any given time, ensuring continuous liquidity in the market. Post the “Big Bang” in October 1986, the responsibilities once held by stockjobbers and stockbrokers became integrated into the dual role of market makers who now operate to make profits by leveraging margins and potentially earn commissions while managing the dual pressures of principal trading and agency roles.
Examples
- London Stock Exchange Market Makers: Firms like Barclays and HSBC act as market makers for various securities listed on the London Stock Exchange, continuously providing quotes to trade stocks.
- Nasdaq Market Makers: Firms such as Morgan Stanley and Citadel Securities maintain liquidity on the Nasdaq by buying and selling shares of listed companies and setting bid-ask spreads to earn profits.
Frequently Asked Questions (FAQs)
What is the primary role of a market maker?
The primary role of a market maker is to provide liquidity to the financial markets. They do this by continuously buying and selling securities, thereby facilitating smooth and efficient trading.
How do market makers profit?
Market makers profit through the bid-ask spread—the difference between the buying and selling price of securities. They buy securities at a lower price (bid) and sell them at a higher price (ask).
What was the effect of the ‘Big Bang’ on market makers?
The ‘Big Bang’ in October 1986 abolished the historical fixed commissions and integrated the roles of stockjobbers and stockbrokers, allowing market makers to act as both principal and agent, increasing competition and cost efficiency.
What is a ‘Chinese wall’ in the context of market makers?
A ‘Chinese wall’ refers to the ethical barrier within a firm to prevent conflicts of interest, ensuring that sensitive information between the trading side and advisory side is not leaked or misused.
Why is liquidity important in financial markets?
Liquidity ensures that securities can be bought or sold quickly without significantly affecting their price, providing more stability and confidence in the market.
- Bid-Ask Spread: The difference between the price at which a market maker buys (bid) and sells (ask) securities, representing their profit margin.
- Big Bang: A significant deregulation of financial markets in the UK in 1986, which restructured trading practices and introduced electronic trading.
- Principal Trading: When market makers trade securities for their own accounts rather than executing orders for clients.
- Stockjobber: Historical term for a market professional who traded for their own account and could only deal through a stockbroker.
- Chinese Wall: An information barrier within financial institutions to prevent conflicts of interest between different divisions.
Online Resources
Suggested Books for Further Studies
- “Market Liquidity: Asset Pricing, Risk, and Crises” by Thierry Foucault, Marco Pagano, Ailsa Röell
- “Trades, Quotes and Prices: Financial Markets Under the Microscope” by Jean-Philippe Bouchaud, Marc Potters
- “Trading and Exchanges: Market Microstructure for Practitioners” by Larry Harris
Accounting Basics: “Market Maker” Fundamentals Quiz
### What is the main function of a market maker?
- [x] Providing liquidity in the financial markets by buying and selling securities.
- [ ] Advising investors on financial decisions.
- [ ] Only creating buy orders for securities.
- [ ] Setting corporate financial policies.
> **Explanation:** Market makers provide liquidity by continuously buying and selling securities, ensuring the markets remain active.
### How do market makers earn their profits primarily?
- [ ] Through service fees.
- [x] Through the bid-ask spread.
- [ ] By issuing dividends.
- [ ] Through interest rates.
> **Explanation:** Market makers profit from the bid-ask spread, which is the difference between their buying price (bid) and selling price (ask) for securities.
### What historical event significantly changed the role of market makers in London Stock Exchange?
- [x] The Big Bang in 1986.
- [ ] The market crash of 1929.
- [ ] The introduction of the Euro.
- [ ] World War II.
> **Explanation:** The Big Bang in 1986 deregulated the financial markets in London, updating trading practices and integrating roles separating market makers from previously fixed commissions.
### What term describes the ethical barrier to prevent conflicts of interest within firms?
- [x] Chinese Wall
- [ ] Firewall
- [ ] Hedge Fund
- [ ] Audit Wall
> **Explanation:** A Chinese Wall is an information barrier within finance firms to prevent confidential information from passing inappropriately between division areas to avoid conflict of interest.
### Under the changed rules from October 1986, how do market makers increase cost efficiency?
- [ ] By lowering service quality.
- [x] By functioning both as principals and agents.
- [ ] By increasing transaction fees.
- [ ] By implementing high-frequency trading systems.
> **Explanation:** After the 'Big Bang', market makers could act as both principals and agents, reducing costs linked to dealing solely through intermediaries and improving market efficiency.
### What term describes market makers' practice of buying and selling for their accounts?
- [ ] Agency Trading
- [x] Principal Trading
- [ ] Retail Brokerage
- [ ] Margin Trading
> **Explanation:** Principal Trading refers to market makers conducting transactions on their accounts rather than executing client orders.
### Who traditionally performed the role that was taken by market makers after 1986 on the London Stock Exchange?
- [x] Stockjobbers
- [ ] Hedge Fund Managers
- [ ] Credit Analysts
- [ ] Investment Bankers
> **Explanation:** Prior to the changes brought by the Big Bang in 1986, stockjobbers performed the trading role market makers now fulfill.
### Why are market makers crucial for financial stability?
- [ ] They control the interest rates.
- [ ] They hand out free market advisories.
- [x] They ensure the market has sufficient liquidity.
- [ ] They regulate market demand and supply.
> **Explanation:** Market makers play a pivotal role by providing continuous liquidity, ensuring that securities can be transacted smoothly without causing market volatility.
### What is a key challenge for market makers in their dual role as both principal and agent?
- [ ] Increasing revenue.
- [x] Managing conflicts of interest.
- [ ] Day trading decision-making.
- [ ] Setting corporate strategy.
> **Explanation:** Market makers face the challenge of separating interests when trading for their accounts while ensuring fair dealing as agents for their clients, hence managing conflicts of interest effectively is vital.
### What does the 'Chinese Wall' prevent in a financial organization?
- [ ] Corporate espionage.
- [x] Information flow between divisions to avoid conflict.
- [ ] Unauthorized trading.
- [ ] Shareholder interference.
> **Explanation:** The Chinese Wall ensures sensitive information doesn’t leak between different units within a firm, aiding in preventing conflicts of interest in multi-functional financial institutions.
Thank you for taking this comprehensive walkthrough of market makers and tackling our sample quiz questions. Keep honing your financial acumen for excellence in the markets!
