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December 23, 2022

Market Making

How Do Market Makers Grease the Gears of Finance?

Market makers make the financial world go round. The title “market makers” might seem a bit Hollywood, but make no mistake—they play a crucial role in your ability to buy or sell products in the FX market. So what do these elusive market makers do?

market-makers

What IS A Market Maker?

Market makers are financial market participants whose job is to consistently offer a two-sided market for a particular asset or class of assets. Two-sided means they will offer to buy (bid price) and quote a price to sell (ask price). Think of the bid as the wholesale price and the ask as the retail price. They buy at a wholesale price and sell at a retail price. Their role is to ensure liquidity in the markets, meaning the market has enough trading volume so trades can be made easily.

Market makers are financial market participants whose job is to consistently offer a two-sided market for a particular asset or class of assets.

The Job of an FX Market Maker

  1. Sets bid (wholesale) and offer (retail) prices within currency pairs
  2. Commits to accepting deals at these prices within set constraints
  3. Takes the resulting exposure onto their book (at least initially)

Market Maker Example

Market makers exist outside the world of financial markets. Let's take CarMax as an example. They are a market maker for cars. They will buy your car at a wholesale price and then turn around and sell that same car to a buyer at a retail price. They make their profit on the difference between the two prices. FX dealers do the same thing, profiting by constantly buying currencies at the bid (wholesale) and selling at the ask (retail).

The big difference is that car prices change slowly, so the risk of the car changing price over the course of several minutes or hours is unlikely. However, FX markets can move fast, so market makers like to lay their risk off daily to ensure they don’t carry too much risk over a long period of time. In other words, they make markets by getting in and out of trade facilitation quickly.

Designated Market Makers

Designated market makers are usually required to provide a market at all times for their specific asset. During periods of elevated volatility, market makers will widen the spread to offset the higher risk they take. Due to the number of securities needed to facilitate the volume of purchases and sales, most work for or represent large financial institutions.

How Market Makers Set Prices  

  • Use prevailing rates quoted elsewhere
  • Exposure–what positions they already have on their books
  • Speculation on the future performance of the currency pair
  • Volume available at the prevailing market rate and volume of the deals

Market Checkout

Market makers are an essential component of a liquid, orderly marketplace. They ensure that participants can buy or sell at competitive prices. Under normal conditions, they maintain tight spreads and make their profits on the high volumes they transact.

As noted above, the exchange sets the margin amounts for all futures contracts. Margin requirements can change at any time, depending on the conditions of the market. It is common for exchanges to raise margins when volatility increases or the market is subject to impactful news events (like Brexit). Margin changes are retroactive, so customers should be prepared to add funds immediately if the requirements change.

Takeaways

  1. Market makers are financial market participants whose job is to consistently offer a two-sided market for a particular asset or class of assets.
  2. A two-sided market means they will offer to buy (bid price) and sell (ask price), much like buying at wholesale (bid) and selling at retail (ask).
  3. A market maker’s role is to ensure market liquidity, meaning the market has enough trading volume so trades can be made easily.

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AI Hedging for the Future. Empowering organizations to intelligently manage their Foreign Currency Exchange Risk with AI and Automation at scale in the cloud.

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