The Market Maker – Truth and Myth

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Many of you have heard that market makers are on the stock market. That’s true. This term, however, is under the guise of wild conjectures and conspiracies. So, what is the truth and what is the myth?

In this article, we try to objectively analyse who the MM is on the stock exchange and what activities, functions and goals it pursues.

Read in this article:

  1. Who are Market Maker (MM)?
  2. Who can become a market maker?
  3. In which cases will Market Maker status be revoked?
  4. Can a market maker manipulate the price?
NYSE Market Maker

How does a market maker work?

An MM is not a mystical wire-puller. An up-to-date list of MM will be published on the stock exchange website. Here are the links to the respective resources:

There you will find official information about which MM is connected to which instrument.

When we analyze an agreement between an MM and an exchange, we will find that an MM is a person providing services to the exchange to support prices and/or trading volume on different financial markets.

While it is more or less clear at supportive prices and you can find a spread for two-way price quotes from market makers on the stock exchange websites, the information to support trading volume is unfortunately not available at all.

The lack of information to support the volume of trading suggests that MM’s trading volume could be artificially generated. This may be done when the liquidity of various financial instruments needs to be increased in order to attract participants from transactions.

In this case, the following question is open: are the volume of instruments traded real? In other words, are the trades we see in the Smart Tape run by independent market participants, or was this activity artificially created by MM?

This question is quite important, as liquidity and demand for the instrument are among the most important criteria in the selection of the market. The imitation of active MM attracts customers.

MM Price regulation

A special feature of market making is that an MM can support price quotes for both purchases and sales of a financial instrument at the same time. It ensures a smoother price movement and eliminates price gaps.

Market Maker Dom Trading

If you monitor the Smart DOM (see figure above), which reflects the limit orders of sellers and buyers, you can be sure that the MM orders are included in these limit orders. When an MM cancels its limit orders, the SmartDOM becomes thinner and there are levels where there are no orders at all.

Market Maker shema

How do I recognize the presence of a market maker?

In fact, it is impossible for a beginner who monitors the SmartDOM to identify whether a market trader is in it or not. Since the terms of the contract provide for certain exceptions to the rules.

For example, it is not mandatory for an MM to be present on the market during the entire trading session. If a market maker is present on the market during 50 of the trading session period, this can be considered to be the proper execution of the agreement. An MM should be present on the market for a period specified in the agreement. Its maturity depends on the stock exchange and the instruments listed by the MM.

However, some information helps to identify the presence of a market maker in the SmartDOM. For example, information about the minimum contract volume for a market maker for certain instruments helps to determine the price level at which he is present.

If a minimum volume is set for an MM (e.g. 1000 contracts) and the general volume in the SmartDOM on each price is not more than 500 contracts, it can be assumed that the MM will enter the market on 1,000 contracts or more.

In addition, MM’s obligations typically provide two-sided fixed spread quotes, which means that a market maker’s order with the same volume should be present on the opposite side of the Smart DOM.

MM use algorithmic trading and apply special trading robots to meet your contract terms.

Who can become a market maker?

Any trading participant could obtain MM status. And it is necessary to perform the functions of the Market Maker in order to maintain the status. The minimum funds required for this activity can therefore be calculated on the basis of a minimum order volume, provided that you know the extent of the guarantee collateral for a contract.

The easiest way is to become a market maker on the cryptocurrency exchanges. All those who trade Limit Orders are considered market makers in this area. If you place an order in SmartDOM to buy 0.001 Bitcoin, you can rightly consider yourself an MM.

in these cases, the MM status is revoked

If the exchange acknowledges the dishonest activity of the Market Maker, it may decide to annden the status of such a market maker. We have not found any specific criteria for dishonest behavior of an MM. Due to business practice, non-compliance with the terms of the contract may be regarded as dishonest conduct.

Can a market maker manipulate the price?

With regard to the obligations of an MM, its main task according to the contractual terms is to be present in the DOM in the form of limit orders. A distance from the last price is determined by a market maker himself, but this should not be greater than a certain threshold. Thus, the activity of the MM itself is not linked to the pressure on price and manipulation with the expectations of other market participants.

At the same time, a market maker is the same as the other market participants. Except that he has additional obligations to the stock exchange and receives compensation for it. The standard agreements with market makers do not include requirements that limit the market maker’s activity on the stock exchange aimed at generating added value. A market maker thus has the right to use prohibited methods to influence the price.

Due to the fact that an MM resists strong market movements, its positions could have a negative margin. Therefore, the activity of market makers is associated with high risks.

Conclusion

From the analyzed materials and documents we can conclude that the activity of MM is necessary for trading to support the prices of supply/demand or trading volume. Nobody needs empty markets.

The activity of the MM does not oblige it to shift the price, to manipulate the opinions of other market participants, but does not prohibit this. Unfortunately, the exchanges do not offer other market participants the opportunity to track MM’s trades and orders, so some of the volume traded may not make economic sense (since market makers support the visible – the trading volume).

That’s why we recommend that you build your trading system based on volume analysis. These should have extreme indicators as they reflect the activity of a broad circle of traders with a higher probability. Such quantities are usually generated in the event of the renewal of high and low levels, the erupting or publication of economic news.

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