When most people imagine financial markets, they picture a bustling stock exchange floor or a flashing screen of green and red numbers. Behind this activity lies a quieter but essential function: market making. The work of market makers forms the backbone of nearly every modern exchange, yet many outside finance don’t know what they do or why their role matters.
What Is Market Making?
Market making is the practice of continuously quoting both buy and sell prices for financial assets, like stocks, bonds, and securities. For those of us who do not regularly trade stocks and securities, let’s take an example of a more common market maker.
Imagine walking into a currency exchange booth at an airport. The booth displays two prices: what they’ll pay to buy your dollars and what they’ll charge to sell you euros. The difference between these prices, called the spread, is how the booth operator makes money. In this analogy, the booth operator is a market maker—by allowing anyone to trade currencies at publicly stated prices, they have made a market for currencies.
Financial market makers operate on the same principle but at a much larger scale and speed. When someone wants to buy or sell shares of a company stock or trade in some cryptocurrency, a market maker is likely on the other side of that transaction, willing to sell or buy immediately and at a publicly quoted price.
The existence of market makers means that traders never have to wait to find another person who wants to trade. They act as liquidity providers, without whom markets would be much less efficient, as buyers and sellers would waste significant time finding each other.
How Market Makers Work
Let’s consider another example that details how market makers operate and, importantly, turn a profit. Imagine a corner store that buys and sells baseball cards. The store owner might pay $8 for a rare card, then turn around and sell that card to an enthusiast for $10. The $2 difference covers the owner’s costs and profit margin. Market makers operate similarly but at a massive scale and with razor-thin margins.
Another key difference is that market makers don’t particularly care if asset prices rise or fall. They only care that people are buying and selling, regardless of the price, as they make money by “capturing the spread” between the buying and selling prices.
Despite the apparent safety of their price-neutral position, market makers must constantly juggle various risk factors. For example, the risk of holding too much of an asset on hand. This is called “inventory risk.” Since prices in modern financial markets can move quickly, if a market maker holds a large amount of an asset that suddenly loses value, they stand to incur significant losses. Therefore, a core part of a market maker’s daily responsibilitie is balancing the amount of each asset on hand by adjusting prices in real time.
To do this effectively, market makers must carefully monitor the state of the markets and continuously update their quotes, sometimes thousands of times per second, based on new information, trading patterns, and their current inventory positions.
The Evolution of Market Making
Market making has transformed dramatically in recent decades. Before the 1990s, market makers were primarily human traders standing on exchange floors, using hand signals and paper tickets to indicate buy and sell prices. They maintained their order books manually and relied on personal relationships and intuition.
With the advent of electronic trading, everything changed. Modern market makers rely on sophisticated algorithms, artificial intelligence, and dedicated fiber-optic connections that can transmit data in microseconds.
The best market makers now succeed by combining quantitative expertise with technological excellence. To generate accurate pricing models, trading systems must process massive data flows as quickly as possible while also executing trades in microseconds. To further improve speed, market makers spend millions to locate their servers as physically close to exchange matching engines as possible. This reduces the delay between market movements and their response. In such a high-stakes game, even centimeters can make a crucial difference.
The 2008 financial crisis triggered another shift. New regulations like Basel III and the Dodd-Frank Act forced large banks to reduce their market-making activities, creating more opportunities for specialized electronic trading firms. Companies like Citadel Securities, Virtu Financial, and Jane Street are now powerhouses that handle significant portions of daily trading volume across multiple asset classes.
Why Market Making Matters
Market making provides several crucial benefits to financial markets. First, it ensures liquidity — the ability to buy or sell assets quickly without significantly moving prices. Without market makers, investors would likely struggle to find counterparties, leading to delayed transactions and wider spreads.
Second, market makers help establish fair prices through a process called price discovery. By continuously updating their quotes based on supply and demand, they help reveal the true market value of assets.
Consider what happens when unexpected news affects a company. Market makers immediately adjust their quotes, helping the market process new information efficiently. When markets are experiencing stress, they absorb temporary imbalances between buyers and sellers, reducing volatility.
This function isn’t just important for large institutions. Every retail investor who executes a trade through platforms like Robinhood or Schwab likely interacts with market makers. These firms ensure your order executes immediately rather than waiting for another individual investor to take the opposite side.
The Future of Market Making
Market making continues to evolve in tandem with technological advancements and structural market changes. Artificial intelligence and machine learning now power many decision-making systems, allowing firms to process more data and adapt more quickly to changing conditions.
The rise of cryptocurrency markets has also created new opportunities and challenges for market makers, who now must operate across dozens of exchanges with varying rules and infrastructure. Decentralized finance (DeFi) platforms present novel market-making models where algorithms provide liquidity directly through smart contracts.
As financial markets continue expanding across asset classes and geographies, the quiet work of market makers remains essential to their functioning. Their behind-the-scenes role ensures that when you decide to buy or sell, someone’s always ready on the other side of that trade.
