What is Market Making
Financial Markets
A financial market is a space where participants can trade securities or other financial assets. Well-known examples include stock exchanges like the New York Stock Exchange, but there are many types of markets worldwide, each with specific mechanics and unique assets. Most trades now occur online, although some in-person trading still happens. In the Bitcoin world, a market is any platform connecting Bitcoin buyers and sellers.
Who Participates in Markets
In every market, there are several participants playing key roles:
- Traders: Traders engage with the market by buying or selling assets. Each trade has a buyer and a seller representing opposite sides of the transaction. Traders can switch between buying and selling and may trade multiple assets if available on the platform. Beyond trading, markets serve as a valuable reference point for prices or allow traders to place orders that might not be filled immediately.
- The Market Operator: Markets can be either centralized or decentralized. Centralized markets, often managed by a single organization, bring organization, transparency, and trust. The market operator ensures fair trade execution, maintains participant records, provides market data, and offers the platform for trading. Decentralized exchanges, on the other hand, allow direct peer-to-peer trades without a central authority but often lack the efficiency of centralized counterparts.
Market Mechanics
There are two primary ways to place an order in a market:
- Market Order: A market order is a request to buy or sell an asset immediately at the best available price. It requires only the trade direction (buy or sell) and the quantity. For example, a market order to buy 100 shares of Apple will purchase those shares at the lowest available price.
- Limit Order: A limit order specifies a desired price, meaning the trade only executes if that price can be met. It requires the trade direction, quantity, and limit price. For instance, a limit order to buy 100 shares of Apple at $100 will only execute if Apple’s stock reaches $100 or lower. Each trade involves an aggressor and a passive participant. The aggressor places an order that executes immediately against an existing order, while the passive participant has an order waiting on the market to be matched by an incoming aggressor. Passive participants are also known as makers, and aggressors are called takers.
Trades often create a bid-ask spread—the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. This spread can make trading slightly more expensive since buyers pay slightly above the mid-market price, and sellers receive slightly below it.
Market Makers
Market makers play a key role by constantly maintaining buy and sell orders for the same asset, ensuring liquidity and minimizing the bid-ask spread. By always being willing to buy at a lower price than they sell, market makers earn a profit from the spread. Their activity keeps trading smooth for all participants by reducing the gap between buy and sell prices. Unlike traditional traders, market makers typically profit through these mechanics rather than relying on asset appreciation.
Market makers need substantial liquid capital to keep trades flowing. Most market makers are large financial institutions due to the capital requirements and infrastructure needed to operate effectively.
Trading Fees
Whenever a trade is completed, the market operator charges a fee for facilitating the transaction. Fees vary based on the market, asset, trade size, and whether the trader is a maker or taker. Typically, more liquid assets have lower fees, and makers pay lower fees than takers.
Final Thoughts
- Financial markets facilitate the trading of financial assets, typically managed by a company that ensures fair trading practices.
- Market mechanics create a bid-ask spread, the gap between the highest bid and the lowest ask price.
- Market makers add liquidity to markets by buying and selling the same asset, earning profits through the bid-ask spread.