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In a liquid asset like SPY, is there any market maker making markets? It seems that with such tight spreads , there is no incentive for the market maker to operate in this underlying. But then again, without a market maker, how are bid and offer prices being set?

So the bottom question is...do market makers deal in highly liquid assets. If yes, how they make money or do they have to do it just because of their duty?

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    Why would money makers needto deal in highly liquid assets? The whole point of money makers is to provide liquidity. – littleadv Nov 7 '14 at 16:17
  • Thanks. But in absence of market makers, who is providing the liquidity in SPY? Just retail traders? – Victor123 Nov 7 '14 at 16:47
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    Yes. While there may be a nominated market maker, there's no necessity for it to make market if the market makes itself. – littleadv Nov 7 '14 at 16:48
  • Thanks. Now I get why people say that SPY cannot be manipulated by MMs. – Victor123 Nov 7 '14 at 16:53
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First, as @littleadv mentions, and as I've pointed out before, anyone who participates in a market using limit orders (which, by the way, should be every non-professional investor) is by definition a market maker. So, I will assume that your question pertains both to official market makers and to "retail investors" using limit orders.

When you remark that there are such "tight spreads" in "liquid assets", what you are really saying is "wow, look at all the market makers in these products!" That's the benefit of electronic trading and algorithmic traders -- millions of participants each with their own opinion of the value of a financial instrument, trying to find people who have very specifically opposing opinions of the value of that same instrument. This is called price discovery, and is the entire point of financial markets.

So, you ask why are there all these market makers present to create such tight spreads in assets like SPY? Answer: Because they can make money in these markets:

Imagine (towards a contradiction) that market makers thought they couldn't make money by offering tight spreads in SPY, and so SPY had a wider spread than it actually does. For example, say the highest bid for SPY was $99.98 and the lowest ask was $100.01. Now imagine that a market maker with perfect knowledge of the future came along knowing that he would be able to sell SPY for $100.01 in 5 minutes. Then he would load up as many buy orders as he could for $100.00 or lower. (He wouldn't bid $100.01 or higher because those trades would not be profitable according to his information -- at least not 5 minutes from now.) So the spread had previously been $0.03 and then suddenly it was $0.01, all because a market maker with better information came along and realized he could make money by creating a tighter market!

Now, nobody has perfect knowledge of the future, which is why markets are never infinitely tight or infinitely liquid. Each market maker has to weigh possible profits against the probability that those profits will actually turn into losses. But if one market maker decides not to participate in a particular instrument, there's bound to be another market maker who will happily take his place. So the very fact that there are so many market participants with resting buy/sell orders for SPY right now is proof that there are market makers able to make money doing so. If they could not make money, they wouldn't be there, and the spread would be wider.

10-15 years ago, before electronic trading and algorithmic trading, the number of market participants was far lower, and the spreads were far wider, meaning retail investors like you and me had a much harder time making money. The only people making money were the institutional investors, the brokers, and the exchanges. Now that all these new millions of players are present in the market, retail investors like you and me get to participate and make money too.

  • Thanks for awesome answer. When you say: "anyone who participates in a market using limit orders is by definition a market maker." I get confused because I always thought retail traders buy at Ask and sell at Bid while MMs buy at bid and sell at Ask. – Victor123 Nov 7 '14 at 21:38
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    Ah, that is not quite correct. A retail trader is just any trader that goes through a retail brokerage -- i.e. does not have direct access or a seat on a stock exchange. But a retail trader can place a limit order just like anyone else, in which case she is making a market (by definition). Or she can "aggress" by buying at the ask/selling at the bid, in which case she is not making a market. It's probably true that the majority of retail flow is not making a market, but I have no statistics to say for sure either way. – dg99 Nov 8 '14 at 0:02
  • It might be good to note that although you can try to make a market by placing a limit order to buy at the bid (or vice versa), doing so will put you at the end of the line (as it currently stands) so all the orders ahead of you will have to be filled (or cancelled) before yours will fill. – Michael Jan 17 '15 at 19:31
  • @Michael Yes, that's entirely true. By definition a highly liquid product is one that has long lines of people already waiting to buy at the current best bid (and lower) and already waiting to sell at the current best ask (and higher). – dg99 Jan 17 '15 at 19:38

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