What is a Market Maker

What is a market maker?

When you wish to buy or sell a financial instrument such as forex, gold, or cryptocurrencies, chances are high that you will be dealing with a market maker.

Market makers are the counterparties to your trade, this means when you wish to buy, the market maker will provide a bid quote and if you wish to sell, the market maker will provide an ask (or offer) price. As a major provider of liquidity to the market, market makers will always take the other side of your trade, regardless if they believe the trade is likely to be in their interests.

As market makers are the counterparty to your trade, they profit when you lose and lose when you profit. This is why you may sometimes hear them referred to as b-book brokers as they take the other side of the ledger

The role of the market maker

Market makers which will usually be international banks, financial institutions, multinational corporations, private investors, or brokers play two important roles that make trading possible.

Market makers provide liquidity to the market

Firstly they provide liquidity to the market, this is why market makers are sometimes called liquidity providers. Liquidity providers help manage the available liquidity so that supply meets demand in a timely fashion.

Market makers ensure there will be a counterparty

Secondly, market makers guarantee there will be a counterparty to the trade. Market makers continuously provide buy and sell quotes as long as they have available liquidity. Without market makers, assets are likely to be illiquid, as finding someone that has an opposite opinion to your desired trade can be difficult. Market makers will always take the other side of the trade, regardless if they think the price will go up or down.

How market makers make and lose money

Maker makers are said to ‘make the market’, this is because they set both the bid and ask price for each transaction. They provide their own quotes (usually matched to interbank prices) which allow them to buy at the best ‘bid’ price available and sell at the best price on offer. This difference between the bid-ask (or buy-sell) is known as the spread and provide the broker with their source of profits.

The higher the ask price is compared to the bid price, the more profit the market maker gets. This spread compensates the market maker for the risk they take on with the trade. The market maker will always take the other side, regardless of their opinion of the trade so they take on a natural risk by being the counterparty when trading with informed traders.

Market makers can also lose money if the market moves against them and they are unable to respond to these events fast enough. To protect themselves from crippling loses when the market moves against them, Market makers adopt hedging strategies.

Market Maker Brokers aka Dealing Desk Brokers

In order to make a trade, you will nearly always need to connect with a market maker, this inevitably means utilizing the services of a broker. This broker can either be the dealing desk broker or no dealing desk broker.

Dealing Desk (DD) brokers will always be the counterparty to your trades, this means you are dealing directly with them. Even if the dealing desk broker chooses to use another a 3rd party liquidity provider, clients still only deal with the dealing desk broker.

This is different from a no dealing desk broker who connects professional and retail traders with liquidity providers using execution methods such as electronic communication networks (ECN), Straight-through processing (STP), and direct market access (DMA). Clients of STP or ECN brokers do not deal with the broker themselves, in this sense, you could call these liquidity providers wholesale or core liquidity providers.

What a dealing desk broker does when they receive a trade request

Dealing desk brokers have the capability to assess all trade requests that come from their clients. From this point, the broker will internalize the transaction or use a 3rd party liquidity provider to complete the trade. You will never know how the broker sources the liquidity to complete your trade.

Dealing desk broker uses their own liquidity

If the broker decides to internalize the other, then the following will happen:

1. Find a client to use as a counterparty: If existing clients are making buy or sell offers that take the other side, then the broker may use each opposite trade to complete the trade.

Dealing desk brokers will usually opt to complete the trade from their end when:

1. Speed is a priority: Using the broker’s own resources may be faster than connecting with a liquidity provider.
2. The size of the trade is too low: Wholesale liquidity providers don’t find it cost-effective to deal with small positions. Brokers however want to attract and keep clients so will fill this gap.
3.  Save on cost: The broker can save on costs for themselves by using their own liquidity
4. Make fixed spreads practical: Wholesale liquidity providers don’t offer fixed spreads. So dealing desk brokers can better control the spread risks for fixed spreads using their own liquidity

Dealing desk brokers will send the order to a third market maker when:

1. Can’t find a client to internalise the trade: If they can’t find a matching order from the clients then the broker may engage a liquidity provider
2. Lacks liquidity: if the dealing desk lacks liquidity then they may need to use a liquidity provider
3. Large position: If the trader’s position is unusually large, then the dealing desk make not have the liquidity available
4. Incentive: In some cases, 3rd party liquidity providers give dealing desk brokers sufficient incentive to use them

When the broker uses a 3rd party market maker or liquidity provider then the broker is said to be hedging their position.

Can you trust market makers with their quotes?

Since market-making brokers provide their own quote and profit when you lose, it is easy to think it is in the interest of these brokers to manipulate spreads in their favour. Rest assured, this doesn’t happen, at least not with brokers using a good regulator

Reasons market makers spreads are not manipulated:

• Regulation: Good Regulators such as FCA (the UK), CySEC (Cyprus), NFA (The US), ASIC (Australia), FSA (Japan) require brokers to offer fair pricing.  Tier-3 regulators such as IFSC (Belize), FSB (Bahamas) may not be stringent about this.
• Competition: Competition between brokers is intense which ensures prices are close to (if not the same) as interbank rates.
• Liquidity Pools: For price integrity, many market makers simply price match or aggregate prices from a liquidity pool

Advantages and disadvantages of market makers

Choosing a market maker broker does have some advantages and disadvantages and it is worth listing these.

Advantages:

1. Commissions are included in the spread

There are two basic types of trading accounts.

• Standard accounts: which are commission-free or rather have commission costs included in the spread
• ECN or Pro accounts: which are spreads plus commission.

Dealing desk brokers offer standard accounts, so while the spreads are wider, it doesn’t necessarily mean more trading costs. You will need to compare the dealing desk brokers’ spreads with the spreads of the ECN or Pro accounts and also add their commission costs to determine which type of broker offers lowers costs.

While Standard accounts may cost be slightly more, beginner brokers and long-term traders may consider the lack of commission an advantage due to their simpler cost structure.

2. Spreads can be fixed or variable

Market makers can offer fixed or variable spreads, it would be highly unusual for no dealing desk brokers to offer fixed spreads.

Market prices are constantly changing so core liquidity providers don’t benefit from taking on the risk of offering fixed spreads.  Dealing desk brokers however may be prepared to take on the risk to attract clients that prefer a trading strategy of stable prices during times of market volatility.

3. Wider choice of products

Dealing desk brokers commonly offer more products beyond the most popular product common with most brokers. While nearly all brokers offer popular CFDs like forex currency pairs such as EUR/USD, indices, gold, silver, cryptocurrencies you may find dealing desk brokers offer less common options such as bonds, interest rates, futures, options, and sectors. You may also find they offer more variety of these products such as forex cross pairs like GBP/AUD and exotics.

4. Offers more features – risk management, education

Dealing desk brokers commonly a more comprehensive trading experience than no dealing desk brokers. Features dealing desk brokers commonly offer include:

• Their own in-house trading platform: designed especially for their clients. No dealing desk brokers use mainstream platforms like cTrader, MetaTrader 4, MetaTrader 5 and Webtrader.
• Extensive risk management: tools to better manage the high risk of trading such as guaranteed stop loss
• Education libraries: (sometimes available for free). Covering topics such as online trading, trading forex and trading strategies

5. No minimum deposits

Many no dealing desk brokers usually have a minimum deposit requirement to open an account, even if it’s just $1. Dealing desk brokers commonly don’t have a minimum deposit.

Disadvantages

1. Conflict of interest

As dealing desk brokers are your counterparty, they do have a natural conflict of interest since they profit when you lose. While most dealing desk brokers operate with integrity, it is something to keep in mind.

2. Lack transparency – can’t see interbank prices

As the dealing desk broker acts as the middle man between the trader and liquidity pools, you will not have visibility to the interbank prices quoted by the liquidity providers.

3. May not accept all positions or provide requotes

Dealing desk brokers may reject your trade or offer a revised quote (known as a requote).

For example, the dealing desk broker is aware the trader is very large and highly profitable, they may scrutinize the trader more closely. At this point, the broker can either process the order internally, hand over the order to an external liquidity provider or reject the order.

4. Artificial quotes

Dealing desk brokers make their own market so can set their own prices. While these prices are usually aligned with interbank prices, they are still set by the broker.

5. Spreads are wider

Wider spreads can mean more trading costs. As a rule, if you are a frequent trader, you are likely to prefer a commission-based trading account.

6. Scalpers often not welcome

Dealing desk brokers lose money when you profit so don’t benefit from scalping practices where traders aim for small profits with multiple trades.

7. Social trading tools not usually available

Many dealing desk brokers have proprietary trading platforms that don’t allow integration with 3rd party products that are no made by the broker. For this reason, most social trading tools are not able to be used with dealing desk brokers trading platforms.

8. Proprietary trading platforms

While you could argue this is a strength as a good trading platform will be designed for the needs of the broker’s clients, it can also be a weakness. Many brokers design their trading platforms so only their clients can use them in an attempt to lock the client into their ecosystem.  This can make it hard to leave the broker should you wish to sign up with a new forex broker or crypto broker.

Conclusion

Market makers play a critical role in making trading possible. Without them, it can be difficult to find a party with liquidity that is willing to take the other side of your trade.

When choosing a broker for forex trading,  you have a choice of a dealing desk broker or a no dealing desk broker. The former is nearly always a market maker while the latter offers ECN, STP, or DMA style pricing.

This article looked at how Market Maker when trading forex works and the featured Market Maker forex brokers offer. Market Makers have a number of advantages but also have some disadvantages. Certainly, you will find Market Maker brokers have features you won’t find with an ECN style broker, nevertheless, no dealing desk brokers remain a popular choice.  With article you should have a good understanding of market makers and why you might choose to use a market maker forex broker.