What Does a Market Maker Do?

Question

Explain, as to an intelligent friend with no finance background, what a market maker does and how it makes money. Then name the two main risks of the business.

Accepted Answer

A market maker continuously quotes two prices for an asset: a bid (where it will buy) and an ask/offer (where it will sell), with the ask above the bid. By standing ready to trade either direction, it sells immediacy, other people can transact right now instead of waiting for a natural counterparty. How it earns: buy at the bid, sell at the ask, repeatedly. If your market is 99.5 bid / 100.5 offer and one buyer and one seller each trade with you, you've made the spread (1) with no remaining position. The business model is collecting many small spreads at scale, not predicting where the market goes. The two core risks: 1. Inventory (price) risk: between the buy and the offsetting sell, you hold a position; if the price moves against it, you lose more than the spread earned. Managed by hedging, position limits, and skewing quotes to shed inventory. 2. Adverse selection: the people most eager to trade with you are the ones who know something you don't. Counterparties self-select: informed flow buys just before prices rise. Managed by spread width, sizing, and fast reaction to information. A strong answer also notes the trade-off: tighter spreads win more volume but earn less per trade

What Does a Market Maker Do?

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