Market makers usually carry a negative connotation. The most common myth being that market makers manipulate prices. However, manipulating prices is a very vague term. Sure, in one way a market maker does manipulate price by charging the spread.
There are also instances when a market maker can charge a higher bid or ask price simply to drive the price higher or lower. Prices can be moved around when the market maker has a motive to offload a risky bet on their books.
However, this “manipulation” is merely a compensation for the risk they carry, regardless of the time they hold the security. The misconception is even wider when it comes to retail online trading brokerages. The average retail investor is often cautious to trade with market makers. Instead, it is generally said to use a broker that executes your trades STP.
A very good example is the Swiss franc currency devaluation in January 2015. Most of the retail traders trading with a DMA (Direct Market Access) broker felt the pinch. As liquidity fell in the markets, traders were left holding the bag with not many willing to hit the bids.
On the other hand, those trading with a market maker were able to control their losses. With market makers, liquidity brought some stability as traders with bad positions were able to offload quickly.
Herein lies the importance of the role of market making.
Another aspect to bear in mind is that market makers do not blindly carry the risk. Whenever risk builds up significantly on a market maker’s trading book, they offset or hedge the risks. Thus, a market maker does not merely buy and sell but they also manage risk.
In most cases, unlike traditional investing which brings the aspect of hedging, market makers hedge solely to contain their risks. At any given time, a good market maker will be risk neutral. This means that they make profits based on the transactions and not on whether the security is moving up or down.
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