What is market making? What is the order book?

Every time you buy or sell stocks, cryptocurrencies or place a bet there is a counterpart. Many times the counterpart will be another user, but most of the time it will be a market maker. Who are they and what do they do?

A market maker (from here onward shortened to MM) is simply a trading business whose job is to constantly make a market on a certain type of instrument, that means when you buy they are selling, and when you sell they are buying.

To further simplify, imagine the theoretical price of a chicken is $100. A market maker will be there to sell the chicken at $101, and will be there to buy at $99. In both cases their profit will be the difference between the theoretical price and the price at which it buys/sell, so 1$.

If the market maker is able to buy at 99$ and quickly sell it at 101$ the effective profit will be 2$, the profit is equal to the bid-ask spread (difference between the ask and the bid).

In both cases the market maker does not speculate on the future price of the chicken, instead it prefers to make a risk-less profit by providing liquidity to people who are selling and buying.

What does it mean in practice? The market is composed of many different players and all of them are will to buy and sell at different prices. Going back to the example of the chicken, you might be indifferent between chicken and beef so you are willing to pay only 95$. Vice versa, say you are a breeder and your “production cost” for chicken is $105, you might want to sell it for $110, realizing a $5 profit. When you put together all the different offers to buy and sell you get the order book, it looks like the picture below.

Orderbook for BTCUSD on FTX
Depth chart for BCTUSD on Coinbase

Breaking some myths

There are many rumors that MM manipulate the markets but this is not simply the case. As written above market makers do not take any directional position in the underlying assets they trade and to do so they must have no inventory. Having no inventory simply means owning no stocks, no crypto or anything else. Market makers have very little risk tolerance and they mostly have two sources of revenues: bid-ask spreads and rebates, if part of the PnL (profit and losses) comes from other sources (such as the direction of the underlying) then there’s a potential problem.

Sources of revenue

Bid-ask spread. The difference between the lowest offer to sell and the highest bid to buy.
Exchange rebates. A smaller but still relevant component of MM revenues are exchange rebates. In most of the exchanges you pay a small fee when trading, part of that fee goes to the exchange and another part goes to the party that was adding liquidity to the order book — eg the Market Maker.

There are two main types of orders in trading, market orders and limit orders. Market orders are filled immediately as they remove the liquidity from the order book. Limit orders do not have such certainty as they add liquidity to the order book and gets filled only when somebody else does a market order.
Every executed trade is thus done by two parties: somebody that wants order execution certainty and uses a market order, and another party that is in less rush and wants price-certainty and uses a limit order.





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