Broker vs. Market Maker: What’s the Difference?

Broker vs. Market Maker: An Overview

The financial market has many different players, including buyers, sellers, dealers, brokers, and market makers. Some help facilitate sales between two parties, while others help create liquidity or the availability to buy and sell in the market.

What is the difference between a broker and a market maker? A broker is a middleman who facilitates the buying and selling of securities for investors, usually on an exchange. A market maker helps create liquidity in the market for investors to buy or sell securities easily. This article will outline the differences between brokers and market makers.

Key Takeaways

• Brokers are intermediaries who have the authorization and expertise to buy securities on an investor’s behalf.
• There are full-service and discount brokers depending on the level of service a client needs.
• Market makers are typically large banks or financial institutions.
• Market makers help to ensure there’s enough volume of trading so trades can be done seamlessly.

Broker

In the financial world, brokers are intermediaries who have the authorization and expertise to buy securities on an investor’s behalf. The investments that brokers offer include securities, stocks, mutual funds, exchange-traded funds (ETFs), and even real estate. Mutual funds and ETFs are similar products in that they both contain a basket of securities such as stocks and bonds.

Brokers are regulated and licensed. Brokers must register with the Financial Industry Regulatory Authority (FINRA) while investment advisers register through the U.S. Securities and Exchange Commission (SEC) as Registered Investment Advisors or RIAs. Brokers have an obligation to act in the best interests of their clients.

Many brokers can also offer advice on which stocks, mutual funds, and other securities to buy. With the availability of online trading platforms, many investors can initiate transactions with little or no contact with their personal broker. Although there are various types of brokers, they can be broken down into two categories.

Full-Service Brokers

Full-service brokers provide their clients with more value-added services. These services may include consulting, research, investment advice, and retirement planning. Many brokers provide trading platforms, trade execution services, and customized speculative and hedging solutions with the use of options contracts.

Options contracts are derivatives meaning they derive their value from an underlying asset. Options give investors the right, but not the obligation to buy or sell securities at a preset price where the contract expires in the future.

For all of these services, investors usually pay higher commissions for their trades. Brokers also get compensation based on the number of new accounts they bring in and their client’s trading volume. Brokers also charge fees for investment products as well as managed investment accounts. Some brokers cater to high-net-worth clients with assets of $1 million or more.

Discount Brokers

With advancements in technology and the Internet, online brokerage firms have experienced an explosion of growth. These discount brokers allow investors to trade at a lower cost, but there’s a catch; investors don’t receive the personalized investment advice that’s offered by full-service brokers.

The reduced commission can range from approximately $5 to $15 per trade. The low fees are based on trading volume, and since there’s no investment advice, employees of online brokers are usually compensated by salary instead of commission. Many discount brokers offer online trading platforms, which are ideal for self-directed traders and investors.

Note

The NYSE employs Designated Market Makers (DMMs) which are market makers that facilitate securities trading.

Market Maker

Market makers are typically large banks or financial institutions. They help to ensure there’s enough liquidity in the markets, meaning there’s enough volume of trading so trades can be done seamlessly. Without market makers, there would likely be little liquidity. In other words, investors who want to sell securities would be unable to unwind their positions due to a lack of buyers in the market.

Market makers help keep the market functioning, meaning if you want to sell a bond, they are there to buy it. Similarly, if you want to buy a stock, they are there to have that stock available to sell to you.

Market makers are useful because they are always ready to buy and sell as long as the investor is willing to pay a specific price. Market makers essentially act as wholesalers by buying and selling securities to satisfy the market—the prices they set reflect market supply and demand.

When the demand for a security is low, and supply is high, the price of the security will be low. If the demand is high and supply is low, the price of the security will be high. Market makers are obligated to sell and buy at the price and size they have quoted.

Sometimes a market maker is also a broker, which can create an incentive for a broker to recommend securities for which the firm also makes a market. Investors should thus perform due diligence to make sure that there is a clear separation between a broker and a market maker.

Some examples of the bigger market makers in the industry include BNP Paribas, Deutsche Bank, Morgan Stanley, and UBS.

How Market Makers Make Money

Market makers charge a spread on the buy and sell price, and transact on both sides of the market. Market makers establish quotes for the bid and ask prices, or buy and sell prices.

Investors who want to sell a security would get the bid price, which would be slightly lower than the actual price. If an investor wanted to buy a security, they would get charged the asking price, which is set slightly higher than the market price.

The spreads between the price investors receive and the market prices are the profits for the market makers. Market makers also earn commissions by providing liquidity to their clients’ firms.

Key Differences

Here are the key differences in specific areas between market makers and brokers:

Market Role

Broker: A broker acts as an intermediary between their clients and the financial markets (usually the exchanges), by buying and selling on their client’s behalf.

Market Maker: A market maker provides liquidity in the financial markets by trading for themselves, constantly quoting bid/ask prices.

Clients

Broker: Brokers work for clients, facilitating the purchase or sale of securities based on the client’s instructions, and earning a commission on the transactions.

Market Maker: Market makers do not have clients but instead trade for their own accounts in order to provide liquidity for the market.

How They Make Money

Broker: Brokers earn money through the commissions they charge their clients for facilitating transactions. They can also earn money by providing other services, such as research.

Market Maker: Market makers earn money on the difference between the bid/ask spread they quote in the market.

Special Considerations

Brokers are required to transact in their client’s best interest, often under fiduciary duty laws in some instances. They have to execute at the best possible price for their clients. Market makers do not have this obligation as they are trading for their own accounts. This can sometimes lead to conflicts of interest as they can take advantage of price spreads and as a result, distort short-term prices.

Do Market Makers Make Money?

Yes, market makers make money. They generally do not make money by charging commissions or fees (though sometimes they can) but rather earn their money through the difference between bid/ask spreads. They buy securities at lower prices and aim to sell them at higher prices. They transact for their own accounts.

Do Market Makers Hold Inventory?

Yes, market makers hold a supply of securities so that they can readily facilitate the buying and selling of securities; in this way, they maintain liquidity in the market. This is their inventory. The inventory needs to be carefully managed by hedging as price fluctuations could impact the value of their securities.

Do Brokers Need a License?

Yes, brokers need a license (or multiple) to facilitate transactions for their clients. Most commonly they need the Series 7 and Series 63 licenses, which are administered by the Financial Industry Regulatory Authority (FINRA).

The Bottom Line

Brokers and market makers are two players in the financial market that have important yet distinct functions. Brokers work for clients and aim to execute the buying and selling of securities at the best price. Market makers ensure that markets have liquidity by constantly quoting bid/ask prices, which facilitates securities transactions.