What is a market maker?

TL;DR Market makers help create a more efficient market by providing liquidity for tradable assets.

But this isn’t Wikipedia. So perhaps to better explain what a market maker does we will need to understand what problem it is that is being solved.

Like a foreign tribe though, every industry has an internal language and different acronyms that can act as a hurdle to the uninitiated. We will avoid that as much as we can, instead opting to apply the methodology of “explain it to me like I’m a five-year-old”.

We will avoid terminology, remove the abstract and will be drawing parallels back to a physical world scenario. The purpose is so we can understand more complex situations and strategies being used, better predict behaviour from the incentives created and spot where opportunities might be found. We will cover:

• What is a market?
• Liquidity and the consequences of not having it
• Maker Taker Fees
• Why OTC?
• Structured Products
• Relationship with Exchanges (traditional and decentralised)
• Automated Market Makers (AMM’s)
• High frequency trading strategies — past, present and future
• Bonus

First, we need to transport this idea into a physical fruit and vegetable market. For aesthetics, we will use an ornate Mediterranean town square where grandmothers visit to purchase their staples from.

Every Saturday, before lunch, Grandma Alma makes the short walk from her apartment to her favourite stall in the town square and buys 4 apples from a vendor named Juan Carlos. If you ask her, she will tell you she likes Juan because of his friendly demeanour and diverse offering of fresh produce but in truth, Grandma Alma is savvy with a euro and knows that when compared to the other vendors in the market Juan Carlos is not only reliable with the quality he delivers but he is also the fairest in price.

Juan Carlos knows a lot about fruit but more about vegetables. He can tell you what is in season, what is grown locally or imported, and is always happy to listen to his regulars complain about the weather and proud grandmothers share stories about their grandchildren. But Juan isn’t a farmer and talking up recipes isn’t how he paid for that almost brand-new Volvo sitting over there with the reflective visor under the windshield. Juan Carlos’ true skill set was forged in his distaste for bringing perishable goods back home and so over the years ensures he doesn’t buy anything he can’t sell by the end of the day.

Marco has never met Grandma Alma, that’s because he does his round of deliveries to different town squares very early in the morning. From his apple orchard located out of town, he sets off before dawn to meet and deliver his wares to Juan Carlos and a dozen others that share that profession.

Ten years ago Juan Carlos was a veg man through-and-through, not that he would admit it now, but back then he considered fruit eaters to be lesser mortals and believed vitamin C to be a myth. That was until he met Marco who told him that “an apple a day keeps the doctor away” and persuaded him to add apples to his Saturday offerings.

Juan knew a thing or two about a cabbage but had never touched an apple in his life, but Marco was so convincing in his argument that he figured an apple has got to be more valuable than a cabbage.

“Four apples for €4”

On his stall he advertised: “Four apples for €4” and by 2pm his doubts were confirmed. Not a single apple had been sold since 9am when a young tourist couple in hiking gear bought pack of four. Determined to never touch an apple again Juan now just wanted rid of the whole experiment. He called Marco and vented his complaints who replied “Just get what you can for them then”. So he changed the sign “Four apples for 0.70c”.

What happened next surprised him — out of almost nowhere a swarm of apple thirsty Grandmas formed an orderly queue next to his stall — all with the same request:

“Four apples for €0.70c por favor”.

After bagging up a few sales Juan noticed the relentless queue of Grandmas continuing to pile on so in private he performed some quick calculations and came to the conclusion — there were too many Grandmas for apples and at this rate he will be out of apples within the hour.

Not a greedy man but also not one to leave money on the table, Juan changed the board reflecting an increase in price.

The board read: “Four apples for €2.00”. Immediately the Grandmas at the front of the queue scowled their faces, withdrew their interest and walked away in search of some pears. The next set of Grandmas looked equally disinterested. Quickly Juan scrubbed the board clean and began writing. After he was finished his offer read “Four apples for €1.10”. He looked up to serve the next customer and was greeted by the warm smile of Grandma Alma, her arm extended, fingers holding a euro coin and a ten cent piece.

Juan peered to the corner where Marcos’ basket containing 80 apples lay then in front of him counting the line of 20 Grandmas. “Four each” he said to himself. They would take the whole lot at this price.

This is how Juan Carlos made the FourApple/EUR market and discovered fair pricing.