Market makers. Truth and myths
Many of you have heard that there are market makers on the exchange. This is true. However, this term is under the cloak of wild guesses and conspiracy. So, what is the truth and what is the myth?
In this article we will try to objectively analyze – who the market maker on the exchange is and what his activity, functions and goals are.
Read in this article:
- Who are Market Makers (MM)?
- Who can become a MM.
- In what cases the MM status is annulled.
- Can a market maker manipulate the price?
How a market maker works?
A market maker is not a mythical wire puller. Actually, a current list of market makers is published on the exchange web-site. Here are the links to respective resources:
You can find official information there regarding what specific market maker is attached to what instrument.
If we analyze an agreement between a market maker and exchange, we will find out that a market maker is a person that renders services to the exchange on supporting prices and/or trading volume in various financial markets.
While it is more or less clear with supporting prices and you can find a spread for two-sided price quotes of market makers on the exchange web-sites, the information about supporting the trading volume is not available at all.
Absence of information regarding supporting the trading volume suggests that the trading volume could be created by market makers artificially. Perhaps, it is done when it is necessary to increase liquidity of various financial instruments for attracting participants of trades.
In this case, the following question is open: are the traded instrument volumes real? In other words, are the trades, which we see in the Smart Tape performed by independent market participants or this activity was created artificially by market makers?
This question is rather important, since namely liquidity and demand for the instrument are among the most important criteria when selecting the market. And imitating active markets market makers attract clients to them.
Market maker price regulation
A specific feature of the market making is that a market maker can support price quotes both towards buys and sells simultaneously on one financial instrument. It provides a smoother price movement and eliminates price gaps.
In case you monitor the Smart DOM (the picture above), which reflects limit orders of sellers and buyers, you can be assured that the market maker’s orders are present among these limit orders. If a market maker cancels his limit orders, the Smart DOM becomes more rarefied and there will be levels where there are no orders at all.
How to detect the presence of a market maker?
In fact, it is impossible for a beginner trader, who monitors the Smart DOM, to identify whether there is a market trader in it or not, since the agreement terms and conditions set certain exceptions from the rules.
For example, it is not mandatory for a market maker to be present in the market during the whole trading session. If a market maker is present in the market during 50% of the trading session duration, it could be considered a proper execution of the agreement. A market maker should be present in the market during a period set in the agreement and its duration will depend on the exchange and instruments quoted by the market maker.
However, some information helps to identify the presence of a market maker in the Smart DOM – for example, information about the minimum volume of contracts for a market maker on certain instruments helps to identify specific price levels at which he is present.
If a minimum volume is set for a market maker (for example, 1,000 contracts) and the general volume in the Smart DOM is not more than 500 contracts at each price level, it could be assumed, if you meet the volume of 1,000 contracts or more, that these are the orders of a market maker.
Besides, the market maker’s obligations usually envisage provision of two-sided price quotes with a fixed spread, which means that a market maker’s order of the same volume should be present on the opposite side of the Smart DOM.
Market makers use algorithmic trading and apply special trading robots for performing conditions of the agreement.
Who can become a market maker?
Any participant of trades could acquire the status of a market maker. And it is necessary to perform the market maker’s functions in order to sustain the status. So, the minimum funds required for this activity may be calculated on the basis of a minimum volume of orders if you know the size of the guarantee collateral for 1 contract.
The most simple thing is to become a market maker on the cryptocurrency exchanges. All who trade limit orders are considered to be market makers in this sphere. Post an order in the Smart DOM for buying 0.001 bitcoin and you can rightfully consider yourself as a market maker.
In what cases the MM status is annulled
If the exchange acknowledges the market maker’s activity dishonest, it could make a decision to annule the status of such a market maker. We haven’t found specific criteria of a dishonest behaviour of a market maker and, on the basis of the business practice, nonperformance of the agreement terms and conditions could be considered a dishonest behaviour.
Can a market maker manipulate the price?
As regards the obligations of a market maker, his main task, in accordance with the terms and conditions of the agreement, is his presence in the Smart DOM in the form of limit orders. A distance from the most recent price is identified by a market maker itself, however, it shouldn’t be bigger than a certain threshold value. Thus, the market maker’s activity by itself is not connected with the pressure on the price and manipulation with expectations of the other market participants.
At the same time, a market maker is the same as the other market participants with the exception that he has additional obligations to the exchange and gets remuneration for this. There are no requirements in the standard agreements with market makers, which restrict the market maker’s activity on the exchange directed at receiving additional benefit. Thus, a market maker has the right to use any unprohibited methods of influencing the price.
Based on the fact that a market maker opposes strong market movements, his positions could have a negative margin, that is why the activity of market makers is connected with high risks.
We can draw a conclusion on the basis of the analyzed materials and documents that the market maker’s activity is necessary for the exchange to support the prices of demand/supply or trading volumes. Nobody needs empty markets.
The market maker’s activity doesn’t oblige him to move the price, manipulate the opinions of the other market participants, however, it doesn’t prohibit it. Unfortunately, exchanges do not provide a possibility for the other market participants to track the trades and orders of market makers, that is why some part of the traded volume could have just no economic sense (since it is done by market makers to support the visible volume of trading).
Namely that is why we recommend you to build your trading system on the basis of the analysis of volumes, which have extreme indicators, since they reflect activity of a wide circle of traders with a higher probability. Such volumes usually emerge in the event of renewal of the high and low levels, breakouts or publication of economic news.