A designated market maker is a broker dealer firm that always maintains quotes on the bid and offer for a specific security in which they are designated as market maker. The purpose of the market maker is to help facilitate smooth trading operations for a particular security. A market maker will hold a certain quantity of a given security in their own inventory, and as their quotes are filled on one side they will balance their inventory by attempting to “take the spread” and re-balance their inventory on the other side of the bid-offer. The market maker’s continuous quoting ensures that adequate liquidity is present on the books at all times for a smooth and efficient trading environment. A designated market maker is also known as a “DMM”, and formerly was known as a “specialist”.
A market maker need not be “designated” to make a market in a given security, however. Any person or institution adding liquidity to a stock’s books by quoting on the bid or offer is participating in market making activities. If a person or institution adds liquidity to the books by quoting a new national best bid or offer, they are said to be “making the market”.
In today’s markets, arguably the most valuable time for a designated market maker to be present is during times of high volatility. Ultra short term trading algorithms known as HFTs will perpetually quote liquidity during times of normal volatility. When volatility increases based on news or other data affecting security prices, HFTs will often pull their quoted liquidity at nearly the speed of light, greatly diminishing the available liquidity in a security right at a moment when it is most needed. The designated markets makers will step in during these times and provide much needed liquidity, and re-establish an orderly trading environment.
While in the past market makers were exclusively human, a significant amount of market making operations are now handled by computer algorithms. Top electronic market makers for US securities include GETCO, Knight Capital, Virtu Financial, and Citadel Group.
Traders may not always be aware that market makers are present, but they should never forget that they help ensure the efficient and orderly markets they require.