Who Do You Buy From When Nobody Is Selling? The Firm Standing in the Middle
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Buying a share requires somebody willing to sell it at that exact moment, which is rarely the case. Firms that quote both a buying and a selling price fill that gap continuously and are paid by the difference.
The problem of matching
A market works easily when a buyer and a seller who want the same quantity of the same thing appear at the same moment, and that coincidence is uncommon outside the most heavily traded instruments. Without something bridging the gap, a person wanting to sell must wait for a buyer to arrive, which makes the price at which they eventually transact uncertain and the delay potentially long. A market maker removes the problem by standing ready to buy from anyone at one price and sell to anyone at a slightly higher one, taking the other side of whatever arrives and holding the resulting position until an offsetting trade appears. That service is what liquidity means in practice, and its value is the ability to transact now at a known price.
How the business works
The economics of the role are straightforward and the risks are not:
- •The firm quotes a bid and an ask, and the difference between them is the spread
- •Profit comes from buying at the bid and selling at the ask repeatedly, in small amounts many times
- •Inventory risk arises because the firm holds positions it did not choose, which can move against it
- •Adverse selection risk arises because somebody trading with you may know something you do not
- •The spread widens when either risk rises, which is why it widens in volatile conditions
- •Some exchanges impose obligations to keep quoting in exchange for privileges
The informed trader problem
The central difficulty is that the firm cannot tell who it is trading with. Most trades come from people transacting for reasons unrelated to any private information, and those are profitable to serve. Some trades come from people who know something that will move the price, and those are losses, because the firm ends up holding the wrong position immediately before the move. Since the firm must quote before knowing which it faces, the spread has to be wide enough to cover expected losses to informed traders out of gains from everyone else. That is why spreads are wider in less actively traded instruments, where a larger share of activity is likely informed, and why they widen dramatically before announcements, and it is the reason a market with more uninformed participants is cheaper for everyone to trade in.
Where else the role appears
The function is not confined to share trading and recognising it elsewhere clarifies what it is. A currency exchange office quotes two prices and profits from the gap, holding inventory in several currencies and bearing the risk that rates move. A used car dealer buys from sellers and sells to buyers at a margin, supplying immediacy to people who do not want to wait for a private sale. A pawnbroker and a secondhand bookseller do the same. A bookmaker quotes odds on both sides and manages the resulting exposure. In every case somebody is paid for standing between two parties who would otherwise have to find each other, and the size of the margin reflects how hard the matching is, how long the inventory must be held and how likely the other party is to know something.
What changed with automation
The role was once performed by people on trading floors with formal obligations and is now performed overwhelmingly by automated systems. Spreads have narrowed enormously, which is a genuine and measurable benefit to anyone transacting. The firms doing it are largely unregulated in that capacity in many markets and have no obligation to continue quoting, which means liquidity can withdraw in seconds when conditions deteriorate, and several rapid market disruptions have been attributed partly to that withdrawal. Speed became decisive, since whoever updates their quotes first avoids being traded against at a stale price, which produced substantial investment in reducing latency. Arguments about whether the arrangement is better overall generally accept that ordinary transactions are cheaper and disagree about what happens under stress.
The takeaway
A firm quoting both a buying and a selling price lets anyone transact immediately at a known price, and earns the difference between the two. It cannot tell an uninformed trader from somebody who knows something, so the spread must cover expected losses to the latter. Automation narrowed spreads substantially and removed the obligation to keep quoting under stress.