What are market makers and how do they impact stock prices?

What are market makers and how do they impact stock prices?

If you want to buy or sell shares, you’re able to do so almost instantly, especially in the modern age, with trading apps. But to buy or sell anything, there are multiple intermediaries your order goes through, and that’s where market makers come in.

Market makers play a vital role in the world of stock trading, helping to execute orders and provide liquidity.

But who are these market makers, how do they make money, and how do they affect the prices that you’ll pay?

What are market makers and how do they impact stock prices?
What are market makers?

Market makers are intermediaries that buy and sell securities to provide liquidity on the market. In the US, market makers are mandated to execute securities at, or better than, the national best bid offer price (NBBO). When your order is executed at a better price, it’s called a price improvement. This NBBO is a reference to the prices on public exchanges and we can interpret the price improvement as the amount better than you would get if your order is executed on an exchange. 

While this all helps the market to flow, how do market makers actually make money? The market makers earn revenue from the spread, which is the difference between the bid and ask prices. 

The bid price is the price that they’re willing to pay for your shares, while the ask price is the price that they will sell them. Naturally, this latter price will be higher.

The profit here (known as the ‘spread’) may be as little as a couple of cents, but with millions of trades each day, this can add up to profits of hundreds of thousands of dollars each day.

So, how does this matter to investors? Ultimately you’re probably never going to deal with a market maker directly, but your broker will, and they receive a small payment for directing orders to market makers. This is known as ‘payment for order flow’, or PFOF.

What are market makers and how do they impact stock prices?
Which brokers make the most revenue from market makers?

So, which brokers are making the most money from PFOF received from market makers? Interestingly, the answer varies a lot from one broker to another, so it’s an important consideration to make when comparing brokers.

Analyzing SEC 606 reports from 2020-21, a total of $2.27 billion was paid to the 12 brokers covered in the analysis, for directing trades to market makers.

TD Ameritrade is the broker that made the largest revenue, with just under a billion dollars in total, followed by Robinhood, one of the market leaders, with PFOF revenue of $532 million.

However, not all brokers profit from PFOF so much. In fact, Fidelity and Vanguard don’t earn a penny through PFOF.

Why does payment for order flow matter? It’s because market makers can discriminate among brokers and could provide more or less price improvement based on the negotiation or deal between brokers and market makers. This means that if your broker has a deal with market makers, you as an investor will likely get a smaller price improvement compared to using a broker that doesn't have a deal with market makers.

Revenue from market makers (data for full years 2020-2021)

What are market makers and how do they impact stock prices?
Which brokers use market makers the most?

Next, we took a look at which brokers are most likely to route your trade to a market maker and which are more likely to send you to a public exchange.

A number of brokers, including Robinhood, direct 100% of trades to market makers, alternative trading systems (ATS) or other execution firms.

Unsurprisingly, these firms are often also the ones that have the highest PFOF revenues, with Robinhood receiving half a million dollars in PFOF in the period analyzed. 

On the other hand, for a broker such as Interactive Brokers, which made a total of $12 million, and Fidelity, which earns nothing at all through PFOF, only 19% and 60% of orders are directed to market makers, respectively.

Market maker use by brokers (in 2020-2021 period)

*Non-directed orders mean that orders not directed (by the client) to a specific trading venue, that are then directed (by the broker) to market makers.

What are market makers and how do they impact stock prices?
Which market makers pay the most to brokers?

So who exactly are these market makers, and how much are they paying for the opportunity to trade your shares?

Again looking at SEC 606 reports from 2020-2021, Citadel emerges as the dominant player, paying out $2.6 billion in PFOF, which accounts for 39% of total PFOF payments in the period.

The second biggest market maker is Susquehanna (G1X | Global Execution Brokers), which paid a total of $1.5 billion in PFOF, followed by the likes of Virtu and Wolverine.

PFOF paid to brokers (2020-2021)

What are market makers and how do they impact stock prices?
Which market makers execute the most shares?

Comparing 10 high-capitalization and meme stocks, we can see that Citadel and Virtu executed the most shares among the analyzed four major market makers.

For example, Citadel executed more than three times more shares than G1X and more than six times more than Two Sigma.

Share execution by market makers (2020-2021)

What are market makers and how do they impact stock prices?
Methodology

All data sourced from SEC 605 and 606 reports and refer to the period of 2020-2021.

Author of this article

Ádám Nasli

Author of this article

Ádám worked in banking and investment, and holds a professional degree in this field. He is a motivated finance expert, having joined BrokerChooser in 2018. He's also eager to help people find the best investment provider for them, and to make the investment sector as transparent as possible. In his spare time, he loves learning new things, especially data science, algo-trading, programming and trading.

Ádám Nasli

Analyst head

Ádám worked in banking and investment, and holds a professional degree in this field. He is a motivated finance expert, having joined BrokerChooser in 2018. He's also eager to help people find the best investment provider for them, and to make the investment sector as transparent as possible. In his spare time, he loves learning new things, especially data science, algo-trading, programming and trading.

Everything you find on BrokerChooser is based on reliable data and unbiased information. We combine our 10+ years finance experience with readers feedback. Read more about our methodology

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