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Understanding the concepts of market maker and broker

Personal Finance & Money Asked by Tim on August 12, 2020

Wikipedia says:

A market maker is a company, or an individual, that quotes both a buy
and a sell price in a financial instrument or commodity held in
inventory, hoping to make a profit on the bid-offer spread, or turn.

I don’t quite understand it.
It may clarify things if we can compare it to similar concepts.
What is the difference between a market maker and a broker, and a dealer?

  1. If I understand correctly, a broker does not actually buy and sell, but match the demand of a buyer to the supply of a
    seller.
  2. About dealer,

    A dealer acts as a principal and trades for his or her own account.

    I wonder what “principal” mean?

  3. Does a market maker actually buy and sell, and for their own account?

    Is a market maker a special kind of broker, or a dealer?

Thanks!

2 Answers

1) A broker does sell and buy shares or financial instruments and forwards them to his client, which will hold them in his account.

2) A dealer is usually employed by a bank and trades on the banks own account. Profits and losses go directly to this account.

3) In my view, anyone who provides liquidity to a financial instrument by simultaneously providing bid and ask quotes (offering to buy and to sell at the same time) can be defined as market maker. Market makers are usually financial institutions or specific firms. In some countries, i.e. Germany, market makers are sometimes being paid for providing liquidity to illiquid shares by the company which issued the shares ("designated sponsorship"). In general market makers profit from high bid/ask spreads.

Correct answer by user13041 on August 12, 2020

I don't know how a market maker makes a profit, but a typical example of a market maker I can think of is an ETF (Exchange Traded Fund).

When you buy an ETF you can see you can buy it as normal shares on the market. But looking at the book of the ETF (where you see buy/sell orders volumes and prices) the interesting thing is that you will find always a huge volume of these shares ready to be sold and another huge volumes ready to be bought. It's like if someone is continuously palcing these giant buy/sell orders on the market. This huge volume of ETF shares are orders placed by the market maker in order to keep the ETF liquid and to keep the price of the ETF on the market linked to the price of the index represented by the ETF itself.

So basically the market maker is the one (I don't know if it's one or more people or just a computer) who continuously pushes in these huge orders on the market.

I see a broker/dealer as someone who simply buys/sells stocks, bonds etc. in the attempt to increase his own capital or the capital of his customers. Usually he is an employee of some bank or of some investments company. You could also be the broker of yourself, if tomorrow you start buying/selling shares/bonds... on the market. I would anyway define you a broker if you spend most of your time doing such job, otherwise i would rather define you just an investor.

Answered by Marco Demaio on August 12, 2020

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