2.2 Market Makers

According to the Enhanced Financial Accounts provided by the US Federal Reserve, the top 10% of US households own $40.5T of $46.5T in corporate equities and mutual funds, or 87%. As more stocks increasingly concentrate into fewer hands, it becomes difficult to trade these equities in any meaningful size without dramatically impacting the price. For example, if someone owns 50% of a company’s shares and tries to sell them at market rate, the mechanical selling of that position would likely crash the value of the stock in the process, limiting the ability of that person to exchange their non-liquid equities for cash. This effect, known as slippage, becomes more severe as stocks continue to concentrate in the hands of the few, and nearly every structural feature of modern stock markets can be attributed to the desire of the wealthiest to reduce the constraint that their wealth hoarding creates.

One of these structural features is the market maker. The role of the market maker is conceptually simple: they take the other side of a trade in the absence of a natural counterparty. Imagine a simple scenario where person A wants to sell a stock at 11:00 AM and person B wants to buy that stock at 11:30 AM. Without a market maker, person A would show up at 11:00 AM with their sell order, and there would be no one to buy it. Then person B would show up at 11:30 AM with a buy order, and there would be no one to sell it. This timing mismatch impeded a natural trade.

A market maker is someone who is willing to temporarily inventory equities to ease these timing mismatches and ensure that trades occur smoothly and continuously. They operate similarly to a water tower. Most of the demand for water within a city is sporadic throughout the day, while the supply of water is set at a continuous rate 24 hours a day. The water tower ensures that the supply of water always matches the demand for water by alleviating these natural timing mismatches. Without the water tower, periods of high demand would result in lower water pressure or water outages, and periods of high supply would result in a lot of wasted water. For this reason, water towers, or market makers, increase efficiency and decrease loss.

For stocks, a market maker provides liquidity and reduces price slippage. When a large participant goes to sell a significant position, the market maker can buy that position at the current market price with the intention to sell that inventory to buyers at a later time. This solves the issue of slippage for the large seller, but it places risk on the market maker, who needs the price of the stock to increase over time to make a profit selling that inventory. Market makers have no desire to hold directional risk, and so they engage in a number of hedging strategies with other instruments.

For stock options, hedging is primarily done via buying and selling on the underlying stocks. For example, if someone buys a call from a market maker with 50 delta, the market maker is then short 50 delta, and can hedge that short side risk by buying 50 shares of the underlying stock. This is the primary mechanism by which options trading impacts the underlying stock market.