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Understanding the concepts of market maker and broker

A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.

I dont quite understand it. It may clarify things if we can compare it to similar concepts. What is the difference between a market maker and a broker, and a dealer?

A dealer acts as a principal and trades for his or her own account.

Does a market maker actually buy and sell, and for their own account?

Is a market maker a special kind of broker, or a dealer?

and the votes-to-close puzzle me. I dont think you should be dinged on this question because you had a string of other questions that werent very popular.

Chris – Ill give you an honest answer on my vote-to-close (I am one of the three). This is a question about back room function. i.e. as an individual investor, I will never interact with a market maker or dealer. Whether low cost or full service, my interface is with a broker. Questions that are business related, even when its an individual about to take the step to business gets shut. I read this question as being of no value to individual investors. We can take the discussion to meta, it may be time to expand the FAQ. Its vague enough that this question may or may not fit. Im open.

1) A broker does sell and buy shares or financial instruments and forwards them to his client, which will hold them in his account.

2) A dealer is usually employed by a bank and trades on the banks own account. Profits and losses go directly to this account.

3) In my view, anyone who provides liquidity to a financial instrument by simultaneously providing bid and ask quotes (offering to buy and to sell at the same time) can be defined as market maker. Market makers are usually financial institutions or specific firms. In some countries, i.e. Germany, market makers are sometimes being paid for providing liquidity to illiquid shares by the company which issued the shares (designated sponsorship). In general market makers profit from high bid/ask spreads.

I dont know how a market maker makes a profit, but a typical example of a market maker I can think of is an ETF (Exchange Traded Fund).

When you buy an ETF you can see you can buy it as normal shares on the market. But looking at the book of the ETF (where you see buy/sell orders volumes and prices) the interesting thing is that you will find always a huge volume of these shares ready to be sold and another huge volumes ready to be bought. Its like if someone is continuously palcing these giant buy/sell orders on the market. This huge volume of ETF shares are orders placed by the market maker in order to keep the ETF liquid and to keep the price of the ETF on the market linked to the price of the index represented by the ETF itself.

So basically the market maker is the one (I dont know if its one or more people or just a computer) who continuously pushes in these huge orders on the market.

I see a broker/dealer as someone who simply buys/sells stocks, bonds etc. in the attempt to increase his own capital or the capital of his customers. Usually he is an employee of some bank or of some investments company. You could also be the broker of yourself, if tomorrow you start buying/selling shares/bonds… on the market. I would anyway define you a broker if you spend most of your time doing such job, otherwise i would rather define you just an investor.

Can you just be your own broker? Will the markets sell to just a regular person? I think brokers are licensed for regulatory purposes in the US. Any retail consumer will have to find a brokerage to do the trades through.

@MrChrister: true, but with the advent of the internet, many banks provide you a web application where you can push in your order directly into the market using the bank system. When I push in an order in the book the order is not filtered by a phisical person in the bank (that would be a broker), my order is visibile immediately on the market book along with all the other orders. So I would say that you could be the broker of yourself.

Ah. and I learned about this recently /blog/2012/06/18/

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