How Markets Work · Intermediate · 5 min

Market makers and liquidity providers

You can explain how market makers and liquidity providers earn money, why their spreads change, and what it means when your broker is your counterparty.

Someone is always there

You can buy or sell the shares of a large company within a second, at almost any moment of the trading day. That is not luck. Most of the time, another private trader does not happen to want the exact opposite trade at that moment.

The other side is often a firm whose business is to always be there: a market maker or a liquidity provider. Understanding how they work explains why spreads exist, why they change, and why it matters who is on the other side of your trade.

How market makers work

A market maker is a firm that stands ready to buy and sell at publicly quoted prices. Its quote always has two sides: a bid, at which it buys, and an ask, at which it sells.

How they earn. Buy at the bid, sell at the ask, many thousands of times a day. Each round trip earns the small spread.
Their risk. Between buying and selling, the market maker holds inventory. If the price moves against it before it can pass the position on, it loses. Managing that risk is the core of the business.
Why spreads change. When markets are calm and many firms compete, spreads are tight. When news hits or prices jump, holding inventory becomes riskier. Market makers then quote wider, show smaller sizes or step back for a moment, and trading becomes more expensive for everyone.

A liquidity provider is the broader term for any firm that keeps prices available to trade at. In forex and CFDs, private traders rarely see an exchange. Their broker quotes the price and either takes the other side itself or passes the trade on to banks and other liquidity providers.

When your broker or provider takes the other side, it is your counterparty. Then your loss can be its gain. That is not automatically a problem, but it is a conflict of interest. The SEC notes that forex dealers act for their own account and may not offer the best price available. In the EU, investment firms must identify and manage conflicts of interest and disclose those they cannot prevent.

Calm day, news day

A fictional stock on a calm afternoon: competing market makers quote it at 100.00 to buy and 100.02 to sell. A spread of 0.02, about 0.02% of the price.

Then the company announces an unexpected investigation by a regulator. Within seconds:

Market makers no longer know where the fair price is, and every share they hold could lose value fast.
They widen their quotes. Some withdraw completely for a moment.
The book now shows a bid far below and an ask far above the last trade.

Anyone who has to sell right now pays for that uncertainty through a much wider spread. Anyone who waits a few minutes for the dust to settle may find spreads tightening again, at a new price level.

Common mistakes

"Market makers set the price." They quote prices around where the market trades. Supply and demand from all participants still move it.
"They are trading against me personally." They quote to everyone and manage their total risk. They do not care about your individual plan.
"A spread is just a spread." Its width tells you something: how competitive, calm or nervous the market is right now.
Ignoring who your counterparty is. With many CFD and forex providers, the provider itself takes the other side. Read how your provider handles orders.

The takeaway

Market makers keep markets moving and charge the spread for it. Watch how wide they quote: it tells you how calm, or how risky, the moment is.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1How does a market maker mainly earn money?

A market maker buys at its bid and sells at its ask. Done many times a day, the small spread adds up.
2Tap the part of the order book a market maker earns from.

Tap the chart.

The spread between bid and ask is the market maker's margin on each round trip.
3Why do spreads often widen when markets become hectic?

When prices jump, holding inventory is riskier. Wider quotes protect the market maker and make trading more expensive for everyone else.
4Your CFD provider acts as market maker for your trades. What follows?

When the provider takes the other side, its interests and yours can conflict. In the EU, firms must manage such conflicts and disclose the ones they cannot prevent.

of 4 correct.