September 11, 2007
Market Makers are speculators... no more, no less than anyone else who seeks to make money through trading securities. Specifically, a market maker is a company or individual who quotes both a buy and a sell price in a security, hoping to make a profit on the bid/offer spread.
In the United States, most security exchanges employ one or more market makers for each security trading on their respective exchanges in order to provide liquidity in the markets. In other words, a market maker must be willing to buy a security when there is excess supply, and the market maker must be willing to sell the security when there is excess demand to ensure all buyers and sellers can complete their transactions.
Its the selling role of the market maker that causes problems for mainstream investors... when demand is high, market makers are allowed to sell shares they dont own, and havent borrowed, under the cover of options. An option is simply a non-binding agreement to purchase a security at a later date and a specified price.
As one commenter put it: "The market maker exemption dilutes corporate securities by creating an IOU that appears to be an actual security in the purchaser's account." In fact, the purchasers account shows an electronic distribution of the share, but they have no knowledge that it is backed up by a Futures Option, and not a real securities certificate.
The market maker is hoping they will find an immediate seller at a lower price than they paid to acquire the security but if demand is still high, that may not be possible. The futures option protects them. In affect, they are allowed to continue selling shares that dont exist, all the while not fulfilling their obligations to provide real securities backed by corporate certificates, thereby expanding supply and depressing the true open market value of the security.
Remember, the job of the market maker is to keep buying up the excess demand And they will... all the while continuing to pump IOUs into the market, unbeknown to the investors who are buying the securities, until supply exceeds demand, and the price naturally falls.
Ultimately, the Market Maker Exception is a sure win for the market maker... but not so good for the investor.
It must be understood that the function of a market maker is simply to serve as a tool by which the securities exchanges can provide temporary liquidity in a given security - ensuring buyers can find sellers, and vice versa... ensuring sellers can find buyers. In return for this service, market makers earn a fee from the difference between the price available for an immediate sale (bid) and an immediate purchase (ask).
Regardless, Market Makers are private firms that provide a service for profit... just like any other business there is a risk/ reward nature to providing their service. It therefore baffles me why the SEC decided they had the right and responsibility to help minimize the risks of market makers through the Market Maker Exception, and at the expense of mainstream investors.
Instead, and in my opinion, the Market Maker Exception must be eliminated and Free Market principles of risk/ reward and no barriers to entry need to govern market maker practices. Otherwise, investors face a situation where market makers are able to affect the value of their securities by never having to settle the short positions the market makers have taken, vis--vis their options, that have ultimately proven to be in error.
BS Economics, MBA