How market makers provide liquidity

Key takeaways

• A market maker earns the spread by quoting both sides and takes inventory risk to do it. Everything else — hedging, fee tiers, rebates — is about managing that risk and that revenue.
• Liquidity provision is regulated. In U.S. equities, the SEC defines what a market maker is and the rules that shape how quotes interact across venues. ^{[1] [2]}
• The bid–ask spread is the price of immediacy. Whether it is cheap or expensive depends on who is on the other side.

What a market maker does

A market maker continuously posts a bid and an offer. Anyone who wants to trade now can, at the market maker's price. The SEC's investor glossary describes a market maker as a firm that stands ready to buy and sell a security on a regular and continuous basis at a publicly quoted price. ^[1]

The revenue is the spread: buy at the bid, sell at the offer, keep the difference. The risk is inventory: after buying, the market maker is long and exposed to the price falling before it can sell.

Inventory is the whole job

A market maker that only earned the spread would be printing money. It does not, because informed traders hit the quotes that are wrong. When news arrives, whoever is quoting is the last to know and the first to be traded against. The spread must compensate for this adverse selection, so spreads widen when information is arriving and narrow when it is not.

Inventory management follows: skew quotes to shed a position, hedge in a correlated instrument, or pull quotes altogether. Each of these is visible in the order book if you know what to look for, and each is the reason that "liquidity" is not a fixed quantity.

Price discovery and fragmentation

U.S. equity trading is spread across many exchanges and off-exchange venues. Regulation NMS, adopted in 2005, set the framework under which quotes on different venues are protected and orders are routed — the Order Protection Rule and the rules on access to quotations among them. ^[2] The practical result for a market maker is that quoting on one venue means competing with, and being routed around, quotes on every other venue.

Futures are different: a contract trades on one exchange with one central limit order book, so fragmentation is not the issue. Inventory and adverse selection still are.

What the spread tells you

• A tight spread with deep quotes on both sides usually signals low expected information flow.
• A widening spread with thinning depth is the market maker's expression of uncertainty, not a prediction of direction.
• Immediacy is a product. A market order buys it at the spread; a limit order sells it and waits.

What not to conclude

Market makers are not counterparties who want you to lose. They are indifferent to your direction and interested in your information. The trader's practical question is not "who is the market maker?" but "am I paying for immediacy I need?"