Market makers and liquidity providers

What you will learn

• The difference between providing and taking liquidity, and what maker and taker fees are.
• The roles of market makers, designated sponsors, specialists and forex liquidity providers.
• The three cost components that set the width of a spread.
• How to calculate a simple market-making result, including losses to informed traders.

Explanation

Liquidity is the ability to trade a meaningful size quickly at a price close to the current market. A trader who places a resting limit order provides liquidity (a maker). A trader who trades immediately against a resting order takes liquidity (a taker). Many venues, especially crypto exchanges, charge takers a higher fee than makers, or even pay makers a small rebate.

Who provides liquidity

• Market maker: a firm that quotes a bid and an ask at the same time, ready to buy and sell, and earns from the difference.
• Designated sponsor: on Xetra, a market maker with a contract with Deutsche Börse. It must quote for minimum periods with limits on spread and minimum size, and take part in auctions. In return it receives fee reimbursements. Requirements are relaxed in stressed market conditions.
• Specialist: on some venues one firm is responsible for an instrument and sets the quotes or the prices for incoming orders.
• Liquidity providers in forex: forex has no central exchange. Large banks and non-bank trading firms stream prices to brokers and platforms, and a retail broker passes these quotes on, often with a mark-up.
• Ordinary participants: any investor with a resting limit order is also a liquidity provider.

Why the spread exists: three components

1. Order processing costs: technology, venue fees and staff.
2. Inventory risk: after buying from you, the market maker holds shares it did not want. If the price falls before it sells them, it loses. More volatile instruments need wider spreads.
3. Adverse selection: some counterparties are better informed, for example they react faster to news. The market maker tends to buy just before prices fall and sell just before they rise when it trades with them. The spread earned from uninformed traders must pay for these losses.

This is why spreads widen before major announcements and in fast markets: the risk of trading with better-informed or faster traders rises.

Inventory management

A market maker that has built up a long position skews its quotes: it lowers both bid and ask slightly to attract buyers and discourage further sellers. A skewed quote therefore tells you something about the maker's inventory, not about the instrument's value.

When liquidity disappears

Most market makers can widen or withdraw quotes when risk becomes too high; even designated sponsors have relaxed duties under stressed conditions. Liquidity that is plentiful on a calm day can therefore be thin exactly when you most want to exit. Lesson 10 covers liquidity gaps in detail.

In crypto markets, some token projects pay market makers to support trading in their token. Such arrangements are often not public, so visible volume and depth for small tokens deserve extra caution.

Worked example

Hypothetical example: a market maker quotes €49.98 / €50.02 (mid €50.00, half-spread €0.02) for 100 shares on each side.

Assumptions for one day: 1,000 fills of 100 shares each, half buys and half sells, so inventory stays near zero. In 15% of fills (150 fills) the price moves €0.08 against the market maker before it can offset the position. Costs are €0.002 per share.

1. Gross spread income: 1,000 × 100 × €0.02 = €2,000.
2. Adverse selection losses: 150 × 100 × €0.08 = €1,200.
3. Costs: 100,000 shares × €0.002 = €200.
4. Net result: €2,000 − €1,200 − €200 = €600.

Break-even share of informed fills: (€2,000 − €200) ÷ (100 × €0.08) = 225 fills, which is 22.5% of all fills. If informed flow rises above 22.5%, the market maker loses money unless it widens the spread.

Inventory skew: if the maker is long 2,000 shares and lowers its quotes by one cent, it now shows €49.97 / €50.01. A buyer pays €0.01 less than before. Exclusions: rebates, capital costs, taxes.

Common mistake

Practice activity

Use the worked example but change two inputs.

1. The market maker widens its half-spread to €0.03. Keep 150 informed fills. What is the net result?
2. With the €0.03 half-spread, informed fills rise to 250. What is the net result, and what is the new break-even share of informed fills?

Key takeaways

• Makers provide liquidity with resting orders; takers use it and often pay higher fees.
• The spread pays for processing costs, inventory risk and losses to better-informed traders.
• Skewed quotes reflect the maker's inventory, not a hidden view on value.
• Quotes can widen or vanish in stress, so liquidity is least reliable when it matters most.

Next step

The next lesson goes deep into order types, including stops, stop-limits and iceberg orders.