Market Makers and Market Takers Explained

7 min read

What is a Market Maker?

A market maker is a financial institution or individual that stands ready to buy and sell a particular security at any time. They create a market for specific security by setting a bid price (the price they are willing to buy) and an asking price (the price they are eager to sell). The difference between the bid and ask price is known as the “spread,” and it is the market maker’s profit.

Let’s say you want to buy shares in XYZ Corp. The current market price is $50 per share, but you only want to pay $49. You can place a limit order with your broker, indicating that you are willing to buy XYZ at $49. If a market maker is willing to sell you the shares at that price, your order will be filled.

Market makers play a critical role in trading and investing because they provide liquidity to financial markets by buying and selling securities at prices they set.

Market makers make money by buying securities at the bid price and then selling them at the asking price. They profit from the difference between the two prices, which is the spread. The wider the spread, the more money the market maker makes.

However, market makers also face risks. If they buy a security and the price drops, they could lose money if they cannot sell it at a higher price. To mitigate this risk, market makers may use hedging strategies to offset potential losses.

Market makers also charge fees for their services. These fees are typically included in the spread, meaning that the bid and ask prices are slightly wider than they would be if there were no fees. The fees may be fixed or variable, depending on the security and the market.

What is a Market Taker?

Market takers are individuals or institutions that buy or sell securities at the current market price set by the market maker. Basically, market takers are the counterparties to market makers. But what exactly is a market taker, and how do they interact with market makers?

A market taker is a buyer or seller of securities who accepts the current market price set by the market maker. They do not set their own price for the security but instead agree to buy or sell at the current market price. Market takers are essential to the functioning of financial markets as they provide liquidity and volume to the market.

Let’s use XYZ Corp. again to make your point more clearly. Let’s say you want to buy shares in XYZ Corp. You could place a limit order, indicating that you are willing to buy the shares at a specific price. If a market maker is willing to sell the shares at your specified price, your order will be filled. But if no market maker is willing to sell at your price, your order will remain unfilled.

On the other hand, if you decide to buy shares at the current market price set by the market maker, you become a market taker. You are accepting the current market price and agreeing to buy the shares at that price. In this scenario, the market maker earns a profit from the bid-ask spread, and the market taker pays the full price for the security.

Market takers do not earn a profit from the bid-ask spread as market makers do. Instead, they pay a fee to the market maker for their services. 

It’s important to note that market takers may be at a disadvantage compared to market makers, as they are paying the full price for the security and a fee for the market maker’s services. Market takers must be aware of the fees associated with trading and factor them into their trading strategy.

What is Liquidity, and Why It’s Important for Market Maker-Taker?

Liquidity refers to how easily an asset can be bought or sold. A highly liquid asset can be quickly sold for cash, while an illiquid asset may be difficult to sell because there aren’t as many buyers interested in it.

Similarly, a liquid market is one where there are many buyers and sellers, creating a balance between supply and demand. In a liquid market, assets can be easily traded at a fair value, resulting in a small bid-ask spread (the difference between the highest bid and lowest ask prices).

On the other hand, an illiquid market lacks this balance, making it harder to sell assets at a fair price due to a lack of demand. As a result, the bid-ask spread may be much higher.

Liquidity is extremely important for both market makers and market takers, as it determines how easily assets can be bought and sold in the market. 

Trading can become difficult or even impossible without sufficient liquidity, leading to several problems. By providing liquidity, market makers ensure that trades can be executed and that the market functions smoothly.

Why are Maker Fees Lower than Taker Fees?

Maker fees are generally lower than taker fees. That’s because a maker provides liquidity for the order book by placing an order that can be matched in the future. In contrast, a taker consumes the book liquidity by taking an order from the order book and taking away inventory from the store.

Market Makers and Market Takers: Advantages and Disadvantages

Advantages for Market Makers

  • Lower transaction fees;
  • Control over pricing;
  • Reduced risk;
  • Improved market stability;
  • Guaranteed trades.

Disadvantages for Market Makers

  • Obligations to maintain liquidity;
  • Potentially large losses;
  • Competition from other market makers;
  • Limited upside potential;
  • Regulatory requirements.

Advantages for Market Takers

  • No obligation to maintain liquidity;
  • Ability to take advantage of market movements;
  • Potential for larger profits;
  • Reduced risk;
  • Reduced regulatory requirements.

Disadvantages for Market Takers

  • Higher transaction fees;
  • Slippage;
  • Limited ability to control pricing;
  • Limited market influence;
  • Risk of market manipulation.

Shedding Light on Regulatory Oversight

In early 2014, Jeffrey Sprecher, CEO of Intercontinental Exchange (ICE) Group, Inc. – the company that owns the New York Stock Exchange, raised concerns about rebate pricing practices and urged regulators to take a closer look. This was followed by the Royal Bank of Canada’s capital markets group, which claimed that maker-taker arrangements fostered conflicts of interest and should potentially be banned, in a letter to the Securities and Exchange Commission (SEC). As a result, Senator Charles Schumer from New York requested the SEC to investigate the issue.

In a speech in October 2015, former SEC Commissioner Luis Aguilar announced that the SEC was considering a test initiative to limit maker-taker rebates through a pilot program. The pilot program would eliminate maker-taker fees for a selected group of stocks for a trial period to demonstrate how trading in those securities compares to equivalent stocks that retain the maker-taker payment system.

However, in 2020, the U.S. Court of Appeals ruled that this study exceeded the SEC’s authority, and the pilot program was subsequently overturned.

How to Avoid Maker-Taker Fees?

One way to avoid paying high taker fees is to use limit orders instead of market orders. By setting a trigger price and building out an order book, you can potentially minimize the fees associated with taking liquidity. Another option is to become a market maker, which involves providing liquidity to the platform and receiving payment for doing so. This way, you can potentially avoid taker fees altogether and instead receive compensation for helping to build up the platform’s liquidity.

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